The Three Rules
Asset Class Correlations
How to Diversify Your Stock Holdings
The three enduring rules for limiting investment risk are (1) Diversify, (2) Diversify and (3) Diversify.
The volatility of your individual holdings is also central, of course; stocks that jump several percent in a day are obviously riskier than those that move by fractions of a percent. But we can see that effect easily, so though these highly volatile “heartache holdings” grab our attention, and if we’re looking to cut risk, we naturally minimize or eliminate those issues.
But diversifying takes a little more thought, because it’s not very efficient to simply buy some of everything; you’ll have a bunch of clutter that’s hard to stay on top of and hard to manage. And owning scores of investments takes a lot more work than owning a focused portfolio.
So you need portfolio focus to manage effectively … but need to diversity to limit risk.
Diversifying effectively—without clutter—means holding a portfolio of different things, and “different” means they actually behave differently; they must respond differently to financial and economic events.
Correlation is a key measure of sameness or difference between two investments. If two investments behave identically (fluctuate in parallel), their correlation is +1.00. If they fluctuate exactly opposite each other, their correlation is –1.00.
Actual correlation values thus range from +1.00 to –1.00. The more positive the value, the more alike the behavior; the more negative the value, the more opposite the behavior. (A value of zero means there is no relationship—not alike, and not opposite.)
The key to diversifying without clutter is selecting investments that have low or negative correlations. All else being equal, low correlation is good and negative correlation is even better.
(With low correlation, two investments are not often doing the same thing at the same time. With negative correlation, they actually offset; when one holding jumps up, the other likely sinks down, so the combined holding is little changed.)
Investing across different asset classes is the first step in diversification. That’s because different asset classes tend to have low or even negative correlations. Here is a matrix of correlations for four major asset classes: stocks, bonds, commodities and real estate.
The “+1.00” values along the diagonal simply show that each asset class is perfectly correlated with itself.
Of the others, the lowest (most negative) correlation is between stocks and bonds, at –0.48. This negative correlation is the reason why most advisors suggest holding at least some of each. They offset each other somewhat.
Bonds and commodities also have negative correlation (at –0.34) making that combination also a good prospect for reducing net volatility.
But you can’t have “everything.” With bonds and stocks negatively correlated, and also bonds and commodities, it’s not surprising that stocks and commodities are positive. (Not too bad, though, as it’s only +0.50.) The net effect is that commodities behave a little like stocks, and it’s good to have some bond exposure to go with either or both of them.
Real estate is interesting because, despite what many believe, it’s really quite a bit like stocks. Not only is the direct stocks-with-real estate correlation high (+0.81), but the relationship with bonds and commodities is much like the equity relationship with bonds and commodities. The implication is that holding real estate securities (REITs) should be considered part of your equity holding, not a distinct addition to it.
The asset class correlations show that for most investors, holding stocks and bonds—with a dollop of commodities—will suffice.
That still leaves the question of how to diversify among stocks without building portfolio clutter. With literally thousands of stocks available, you can clutter-up your holdings pretty fast unless you have a way to narrow it down.
First, you can capture a great deal of diversification by using market sector ETFs. There are now many sector-based ETF offerings, including sector sets from Vanguard, Fidelity, iShares, ProShares and State Street’s SPDR series.
The most common (and practical) division is among nine key S&P sectors. The SPDR sector ETFs are Basic Materials (XLB), Consumer Discretionary (XLY), Consumer Staples (XLP), Energy (XLE), Financials (XLF), Health Care (XLV), Industrials (XLI), Technology (XLK) and Utilities (XLU).
Each market sector ETF includes dozens of individual companies, giving a kind of diversification, but only within its industry or sector. That’s not really very diverse, because companies within a sector are largely affected similarly by economic, financial or regulatory events.
But combining sector ETFs can increase diversification significantly. Using sector ETFs and a correlation matrix, you can achieve diversification with a remarkably small range of actual holdings.
Consider this matrix of SPDR sector correlations:
The average correlation among all 36 pairs is 0.75, so any pairing with lower correlation than that gives more diversification than the average pairing.
Building a collection of low-correlation pairs will generate a portfolio with low overall correlation with the S&P 500 and diverse (somewhat offsetting) fluctuations among your holdings.
The very lowest correlation (0.59, in red) is for the Financials/Utilities pairing (XLF and XLU).
The next three lowest values (light blue) are for XLF paired with XLV (0.65), XLF with XLE (0.66) and XLU with XLY (0.66).
Over the past five years, these five individual ETFs had annualized volatility ranging from .225 (Health Care) up to .623 (Financials). Their average volatility was .412. But their volatility was reduced when taken together as an equal-weighted portfolio, at .353
But these four low-correlation ETFs don’t necessarily make an optimal portfolio. Optimizing depends on the correlations and the expected returns going forward, and is usually quantified using more complicated math.
We’ll talk about expected returns another time. Meanwhile, when considering sector additions (or deletions), try checking out the ETF correlations to see whether any changes would likely expand or reduce your diversification.
If you methodically tilt toward low-correlation sectors, you’ll gradually cut back on your portfolio’s volatility.
Your guide to ETF sector investing,
Editor of Cabot ETF Investing System
PS: Here is a web site where you can get pair-wise correlations for the nine key sectors, or any pair of stocks you want.