So you’ve been told you should diversify your portfolio for stock investing, you’ve been told it makes for good stock portfolio management, but how can you know whether one of the potential stock investment strategies you’re considering is aiding you in diversifying your personal stock portfolio. Well, one way is to simply invest in different sectors, like Health Care, Technology, Construction, Financials, Real Estate, etc. But, are Health Care and Real Estate really that diversified? How can you know if you really have a good stock trading strategy?
One-way to determine stock trading diversity is through correlation. If two investments are correlated, then generally they will not be considered diversified, and is probably not considered good stock portfolio management, on the other hand, if two investments are not correlated, then they may be good candidates for diversification.
How to Calculate
But, you say, “how do I calculate the correlation between two investments?”. If you use spreadsheet software or have access to spreadsheet, then the ability to calculate the correlation between various investments for aiding in good stock portfolio management is right at your fingertips.
For example, let’s consider Health Care and Real Estate, and let’s assume a good proxy for the Health Care industry is the Health Care Select Sect SPDR (XLV) and maybe a good proxy for the Real Estate sector is the ETF (Exchange Traded Fund) iShares Dow Jones U.S. Real Estate Index Fund (IYR). Retrieving the data for these two symbols from Yahoo!’s Finance web site (a good web site for stock market research) and then using Microsoft’s Excel spreadsheet software with the Tools/Data Analysis/Correlation capability, a correlation coefficient of 0.735 is calculated for XLV/IYR indicating a fairly high correlation between the Health Care and Real Estate sectors. So, adding a health care investment to a portfolio of Real Estate investments is probably not very much diversification. (With respect to correlation, a correlation coefficient of -1.0 represents highly uncorrelated and a correlation coefficient of 1.0 represents highly correlated. For the purposes of this article, it will be assumed that a correlation coefficient of less than approximately 0.5 is a good threshold for determining diversification.)
OK, so now let’s throw in a bunch of sectors and see what happens:
|Health Care (XLV)||1.00|
|Real Estate (IYR)||0.74||1.00|
|Cons. Discret (XLY)||0.81||0.88||0.73||0.89||0.95||1.00|
|Cons. Staple (XLP)||0.26||0.05||0.46||0.52||0.21||0.31||1.00|
From the correlation matrix generated by the spreadsheet, it appears Health Care, Real Estate, Energy, Financials, Materials and Consumer Discretionary are all fairly highly correlated with each other.
Now let’s go back to our original quandary, suppose your personal stock portfolio is invested in Health Care and you want to diversify. Well, from the correlation matrix generated by the spreadsheet, we can see that Consumer Staples, Utilities and Technology are fairly well uncorrelated with Health Care, so those sectors might be good additions for diversification of your personal stock portfolio. Or, suppose we’re invested in Real Estate, in this case attractive sectors for diversification might be Consumer Staples, Industrials, Utilities and Technology.
The spreadsheet used for this analysis:
A free Excel viewer may be downloaded from Microsoft’s web site to view it at www.microsoft.com (search for Excel viewer).
Note: For this article, the analysis was performed over a five-year historical time span.
[tags]investment diversification, exchange traded fund, etf, stock investing, stock portfolio management, stock investment strategies, stock market research[/tags]