The ‘ABCs’ of Stock Diversification: Always Balance Correlations!

So, you’ve mastered investing basics: you know the principle of buying low and selling high. You can identify various investment instruments such as stocks and bonds, and also analyse historical price trends of securities. But the market is cyclical, and you don’t want your entire portfolio to plummet in a single price correction. 

So, how can you alleviate these inherent risks?

Correlate to mitigate

Correlations measure how closely the prices of two or more stocks move in relation to each other. Diversifying your portfolio's correlations can help amplify cyclical gains, while decreasing your overall loses during seismic shifts. 

They can be positive, negative, or neutral, being measured from a value of -1 to +1.

• When stocks have a positive correlation (> 0) they tend to move in the same direction. When one experiences a price increase, the others typically follow suit, implying they’re strongly related. Having positively-related stocks in your portfolio can offer robust returns during favourable conditions.
• A negative correlation (< 0) indicates that stocks tend to move in opposite directions. When one stock’s price increases, the others decrease, suggesting an inverse relationship. Harmonising your base portfolio can stabilise your portfolio during downturns.
• A correlation of zero (0) indicates there is no distinguished relationship between your identified stocks, they move independently of each other. If you own multiple portfolios, zero correlations between them can provide stable risk mitigation.

So, how can I measure stock correlations?

Calculating correlations often involves complex statistics. Fortunately, there are automated resources such as Portfolio Vision that require no mathematical application. I've used their asset correlation calculator to compare Google (Alphabet) and Amazon—which boast a high correlation of 0.77 out of 1.

Newer investors often gravitate toward stocks that align with their personal interests. Therefore, your initial investments are more likely to be tied to similar categories and exhibit a positive correlation—as demonstrated above with Google and Amazon. Please note that positive correlations don’t imply the same percentage of returns, but rather indicate a similar likelihood of occurrent change.

Now, let’s discuss sectors that often aren’t correlated, as owning them is crucial to spread risk—and may enhance your returns.

Healthcare vs. financials: healthcare stocks (including pharmaceuticals and biotech) are influenced by research and development, demographics and FDA approvals. Financials fluctuate due to interest rates, economical conditions and regulation changes.

Tech vs. energy: energy stocks are commonly influenced by oil prices and geopolitical events. Technology primarily changes due to innovation, market sentiment and broader economic trends.

Consumer discretionary vs. staples: discretionary stocks include extras such as travel, entertainment and retail which often perform well during an economic upturn. Staples refer to essential products and services such as food and household essentials, which provide stability during an economic slope.

Materials vs. healthcare: material stocks refer to industries such as chemicals, mining and construction. They fluctuate with commodity prices and construction demand, whereas healthcare changes due to policy, innovation and demographics.

Tech vs. utilities: technology stocks often flourish in times of growth and innovation, yet steep during economic downturn. Utilities, in contrast, are essential and therefore defensive in nature.

Tech vs. real estate: real estate stocks, including REITS are tied to property demand, interest rates and economic conditions—exhibiting low correlations to tech companies, which rely on innovation and mass adoption.

From correlation to application

The sensibility to balance stock correlations allows investors to manage risk and construct portfolios with amplified growth under certain conditions. Next time, I’ll be discussing alpha and beta analysis to help you gauge performance based on an established benchmark.

As a financial copywriter, I’m naturally more stock-savvy than your average wordsmith. Need meticulously-crafted financial content that builds, instead of breaks your bank? Then contact me on LinkedIn for a free consultation.

DISCLAIMER: The information contained herein is for educational purposes only and is drawn for sources believed to be credible. It does not provide financial, legal, tax or investment advice, which should be evaluated relative to each individual’s goals and risk tolerance. I do not endorse the companies, stocks or products mentioned, and they are merely enlisted for explanatory purposes.