Introduction
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This is Ken Leoni Vice President of Marketing here at Stock Rover and in this video, we’ll explain Stock Rover’s powerful correlation feature and show you how to construct portfolios with improved diversification, which translates to less risk. We do this by identifying assets that are highly correlated in a portfolio and replacing them will assets that are less correlated.
Diversifying a portfolio this way is considered the only free lunch in investing. Diversifying reduces the volatility of the portfolio. This can be best be demonstrated with a simple example. If a less diversified, more volatile portfolio is worth $100, and goes up 20% and then down 20% (or vis versa), it will be worth $96. However, if we can reduce the portfolio volatility so that in the same market period, the portfolio goes up 10% and then down 10%, it will be worth $99. That improvement in return is our free lunch from diversification.
What is Correlation?
Correlation is a statistical relationship between asset prices. It is represented by a coefficient that measures, on a scale of -1 to 1, how likely it is that the price of two assets will move together—that is, how likely is it that they’ll both go up or that they’ll both go down.
Correlation is based on daily returns. The daily dividend-adjusted returns of different assets are compared over a given period, typically one year. However, with Stock Rover you can change the period of measurement from 5 days to 10 years.
A positive correlation means pricing between assets are moving in the same direction. As the value increases from 0 to 1 they more closely match. If two assets have a correlation value of 1, this means that they have perfect positive correlation—the pricing is moving in the same direction and in the same proportion 100% of the time.
A negative correlation means pricing between assets is moving in the opposite direction. As the value decreases from 0 to -1 the pricing moves further in opposite direction. If two assets have a correlation value of -1, this means that the pricing moves in opposite directions and in the same proportion 100% of the time.
A correlation value of 0 means that the assets are moving together 50% of the time. In other words, they are equally likely to move together as they are to move in opposite directions. Such assets are considered uncorrelated.
Stock Rover’s Correlation Facility, can be found by first clicking on Portfolios in the grey selector menu. We can choose any combination of tickers that we’d like to correlate from the navigation pane. We can pick specific tickers via Stock Rover’s Quotes List. We can correlate the tickers in a portfolio or multiple portfolios. We can correlate the tickers in a watchlist or multiple watchlists and we can correlate any combination of the three.
I am going to pick 4 tickers that I’ve already added to my Quotes list. I’ve picked Amazon, CVS, McDonald’s, and the S&P 500. Here’s an example of the correlation table which shows the correlation of the daily returns shown over one year.
Note that correlation is calculated over a period of time, and therefore the coefficient can change depending on the period of the calculation. Two tickers could be strongly correlated over a longer time period—say, the past 10 years, but less correlated with a shorter time period, such as the last year. In the Stock Rover Correlation Facility, correlation values will be calculated over whichever time period you select and generally, a 1-year time period works really well. We can see that Amazon correlates most with the S&P 500 at 0.59. We can see that Amazon and CVS are uncorrelated.
Why Does Correlation Matter?
Using correlation information is a way to help you diversify and de-risk your portfolio. A highly correlated portfolio is a riskier portfolio. It means that when one of your stocks falls, it’s likely that all of them will fall by a similar amount. On the other hand, if your stocks are going up, then a highly correlated portfolio might feel pretty good! And while you can never eliminate risk completely, you can build a portfolio with a mix of assets that are less correlated, uncorrelated, or negatively correlated to reduce your portfolio’s overall volatility and potential maximum drawdown.
What is a Good Amount of Correlation?
What is a good correlation? That depends on your tolerance for risk. If you are risk-averse, then you’d want a portfolio where the assets have as little correlation as possible. This is because a portfolio with highly correlated assets will march in lockstep with the potential to experience big swings, both up and down.
While finding perfectly uncorrelated stocks is pretty much impossible, you can aim to have a mix of stocks with varying correlations. This will reduce the volatility and the maximum drawdown of the portfolio, factors that are critical for prudent portfolio construction. It will also reduce the correlation to market benchmarks such as the S&P 500.
Within a portfolio, if you can find assets that have correlations with each other of below 0.70, that would be a good starting point. If you find that many of the assets in your portfolio are correlated at a high level, say over 0.80, you may want to rethink what the portfolio holds. You could actively search for more weakly correlated assets in order to reduce portfolio risk. If you can turn those 0.80 plus correlated assets into other assets you like, and whose correlation to most other assets in the portfolio is lower than say 0.50, that would be a big step forward.
How To Find Diversifying Stocks To Add
For example, let’s consider a simple portfolio consisting of three ETFs; SPY, XLE and XLU. I’ve selected ETFs which represent the S&P 500, Energy, and Utilities.
This would be a portfolio where the asset correlations to each other are fairly low. In this portfolio SPY weakly correlates with XLE at 0.42 and even more weakly with XLU at 0.40. Even better, we can see that the XLE and XLU correlation is -0.05 meaning the two assets are completely uncorrelated.
Portfolio Correlation
Knowing the correlation of your investments will help you manage the riskiness of your portfolio. If all of your assets are highly correlated, then when one of them takes a downturn, it’s likely that all of them will. This “diversification risk”, vulnerability if you will, can be identified using Stock Rover’s Correlation Facility. We have selected the Dividend Grower Portfolio the grid displays the stocks from that portfolio, as well as the Dividend Grower Portfolio itself. You can select additional tickers, portfolios or watchlists to include in the grid. It is simply a matter of checking the boxes in the navigation pane or via “Add a Quote”.
Within the correlation grid, each asset appears as both a row and a column. Any given cell includes the correlation coefficient for the assets in that cell’s row and column. If you lose track of which row and column you are looking at, you can just mouse over a cell to see that information in the tool tip. Let’s mouse over the FedEx / Accenture cell. We can see a correlation value of .26. If you see a column or row with consistently high correlation as we can see here with Northern Trusts that’s a signal that that particular asset is not helping you diversify your portfolio, in which case you should ask yourself if the returns are worth the added risk.
The diagonal set of 1’s are the identity cells—these cells represent the intersection of an asset with itself in the grid. The identity cells will always contain a 1 because a stock is perfectly correlated with itself. But there is more information hidden in this cell—when you mouse over it, you get a tool tip that tells you which assets in the current grid are the most and least correlated with the selected ticker. Here I can see Comerica most correlates with ZION and least correlates with United Health. When I mouse over the portfolio itself, we see the most and least correlated assets in the portfolio. So Northern Trust is the most correlated and United Health is the least correlated.
I’ll set the time period to 1 month to demonstrate another feature of Correlation. We see that some of the stocks are shaded in varying hues of red and purple—this is called the “heat map.” Correlation above 0.50 will show up in one of five shades of red—the higher the correlation, the deeper the color. Correlation below 0 will show as one of five shades of purple; deeper shades indicate more negative correlation, indicating assets that are good for hedging. Grey cells indicate coefficients that fall in the sweet spot between 0 to 0.50—considered a safe zone for the risk-averse investor.
The tool tip is showing that Accenture is slightly negatively correlated with Comerica. Negative correlations are rare for most stocks and ETFs. I’ve picked a shorter period of time here which is really artificially skewing things. The heat map is an optional setting. To remove the colors, uncheck the “Heat Map” box. Let’s set the time period back to 1 Year.
You can also filter the correlation table so it only shows you the correlation coefficients that fall within a certain value range. To do this, click on the “Filter” button and fill in the filter box, I am setting the grid filter to only show correlation coefficients above 0.70. Any column or row with a lot of red still showing signals that this stock is highly correlated with my other holdings, and I may want to examine if the stock’s returns justify its place in the portfolio.
In our sample Dividend Growers Portfolio, things actually behave reasonably well. There is not a lot of red showing after applying the filter. The highest correlation we have is Comerica with Zions Bancorp at 0.92. ZION and a number of other tickers are highly correlated stocks to the portfolio as a whole with values in the mid-80’s. We may want to review ZION to ensure that it’s still offering enough rewards in other ways. A little later in this video we’ll explore how to go about finding a less correlated replacement for ZION. Let’s clear the filter. I’ll also deselect the portfolio.
Adding Benchmarks
You can add more than tickers to the correlation matrix using the “Add a Quote” box at the top. You can also add in whole benchmarks—that is, portfolios, watchlists, screeners, sectors, industries, or indices. To do this, type the name of portfolio, watchlist, industry, or index, etc., in the quote box, just as you would for a ticker, and then select it from the matching results. I’ll add a portfolio and watchlist. This allows you to see how a stock correlates with a relevant benchmark. You can use this feature to see how different portfolios correlate with each other, or see how your portfolio correlates with specific sectors.
I will select a few of the Stock Rover model portfolios to see how they correlate with each other. I’ll start with Dividend Grower, ETF International, FANG Stocks, Growth Portfolio, Value Portfolio, and the S&P 500. I can see for example that both the Growth Portfolio and the Dividend Growers Portfolio have the highest correlation with the S&P 500, with values of 0.81 and 0.75 respectively. We can see that the dividend grower portfolio is least correlated to the FANG portfolio which is surprising. Additionally, the second list correlated portfolio to the dividend grower portfolio is the growth portfolio. So a dividend growth portfolio is not well correlated to a growth portfolio – at least for these models.
So using this table on my real portfolios will tell me how diversified my portfolios are to one another. If one of my portfolios experiences a downturn, I will know how likely it is that the other ones will too. Using the correlation table in this way illuminates how vulnerable I am to diversification risk across portfolios—a fact that without the correlation grid, I would only learn the hard way.
How to Find Diversifying Stocks to Add
While there is no precise methodology for finding low-correlation investment candidates to diversify a portfolio, you can give yourself a head start by first finding a population of stocks that have a relatively low correlation to the portfolio. For example, by viewing the correlation of whole sectors or industries to your portfolio, you may get a better idea of where to start your search.
I’d like to research several sectors that seem promising for providing stocks that could diversify the Dividend Growers Portfolio further. I’ll start by adding Dividend Grower portfolio and then I’ll add a list of ETFs. I’ve picked real estate, energy, consumer staples, utilities, healthcare, and telecom. I’ll use these ETFs as proxies for the sectors. Then I’d hunt for stocks within the promising sectors for additional diversification candidates via screeners or via filtering columns in the Table. Or if I wanted to take a lazier approach, I could just add the ETFs themselves.
Utilities seems to be the most promising sector, at being only slightly correlated at 0.27, then health at 0.43 and staples at 0.49. Of course, I would have to check the correlation of any stocks I like from these sectors against what is already in the portfolio. But by sub-selecting from low-correlated sectors, I would have a head start in finding stocks that would increase diversification.
Adding in a Potential Buy
Let’s go back to our Dividend Grower Portfolio. Remember ZION is highly correlated with the rest of the portfolio. Let’s say we decide that we want to replace ZION with a more diversified stock. Utilities are noted for paying dividends; however, they are not noted for dividend growth generally. The trick is to find a good dividend grower from utilities, which is the least correlated sector.
The Portfolio is loaded in the Table, let’s switch things up a bit. I’ll change by view to be Stock Rover Ratings view, next I am going to right-click on the Utilities folder and show all stocks. The Table is now loaded with some 595 tickers, so let’s narrow things down a bit. I’ll start by filtering on Dividend Rating vs Peers. I want to filter for a score greater than 75. Let’s do the same for Growth Rating vs Peers and let’s finish up with Valuation Rating vs Peers.
We’ve now narrowed things down a bit to 10 utilities which are 7 distinct companies. I am going to select some utilities form the list and load them into the correlation table. We’ll go back to Portfolio Manager, select correlation, and add the tickers. We can see that ENAKF has the lowest correlation with the portfolio at 0.11. I have also highlighted the ENAKF row so you can see that it weakly correlates with every stock currently held in the Dividend Grower portfolio. This ticker looks promising. It could be an excellent choice for diversification if the stock, after researching it, looks like it is a strong buy based on its other merits. It would be my starting place for researching for a replacement candidate for ZION. If ENAKF failed the research process, I would next research Capital Power based on its second-lowest correlation score with the Dividend Grower Portfolio.
Conclusion
We have seen how we can use Stock Rover’s correlation facility to help diversify and reduce risk in our portfolios. However just knowing a stock’s correlation to your other holdings is not enough. As always, further research would be needed to determine if you want to commit capital to any equity that looks promising from a diversification perspective. With that said, I hope you can see how powerful correlation is for examining the diversification risk of your portfolios. Try it out on your own and see what you find.
I hope you found the video useful. I encourage you to explore Stock Rover and see all that it has to offer, as well as check out our other educational videos on our website. Thank you for watching.
