The stock market is notorious for exhibiting tremendous herd behavior. What this means is that over any given time period, there are always groups of stocks moving together. There is a variety of reasons for this including fundamental, industry specific, economic, sentiment and cyclic related factors.
A critical component of profitable stock portfolio construction is to diversify across the market in such a way as to ensure you are not overly exposed to any single 'herd'. Unwittingly creating a portfolio that is only exposed to one or two areas of the market increases your portfolio risk and wastes capital.
This article is focused on correlation cluster charts and will therefore not go into detail on the importance of ensuring you perform the appropriate correlation based analysis when adding positions to your portfolio. For a detailed article on this topic you can refer here: Why diversify your stock portfolio.
For those people who understand the importance of efficient portfolio construction, it is often difficult to get a birds eye view of the stock market. Universally, trading platforms focus on analyzing individual stocks. You are provided with countless technical and fundamental indicators to analyze individual stocks.
The problem is that typically you have no way of knowing how individual stocks relate to each other, or how your stock portfolio relates to the market as a whole.
This is where correlation clustering comes in. A cluster chart is created by first analyzing the correlations of a given group of stocks and then turning that information into what is known as a MST (Minimum Spanning Tree).
MST's have been used for decades in industries such as Telecommunications, Transportation and Water Supply. Over time the financial industry started to realize the benefits of MST's when applied to large time series data sets (ie: the Stock Market), resulting in what is generally referred to as Financial Network Theory.
MST's of the stock market provide an incredibly powerful way of analyzing hundreds of stocks in a single, concise chart. The MST reveals the natural herding behaviour of the stock market providing information that is immediately actionable when constructing a stock portfolio.
The below chart shows a hypothetical portfolio consisting of 12 stocks:
If we reduce the cluster strength using the slider, we see that 3 distinct clusters (or herds) have appeared:
Looking at which stocks have been grouped together, it becomes clear that we have Oil Companies, Gold Miners and Tech Companies:
What is important to note, is that these clusters have not simply been created because of the Sector or Industry the stocks happen to fall in. The clusters have been created as a result of the statistical relationship (ie: correlation) that exists between the price movements of these stocks.
This example was purposefully kept simple. However as your portfolio grows and begins to include a diverse range of stocks, there will be relationships between the stocks in your portfolio that will be impossible to identify without correlation and cluster based analysis.
You will find stocks in your portfolio that have extremely strong relationships to each other that are from completely different Sectors of the market. Inadvertently adding these stocks to your portfolio will increase your risk and waste capital.
This is the power of using correlation cluster charts. They identify similarities between stocks regardless of their underlying business or the Industry they fall in. Stocks which are highly correlated to others naturally cluster together while those with weak or negative correlations naturally have less connections to other stocks. This creates the ability to be hugely strategic in how you allocate your capital across the stock market.
Sector / Industry highlighting
A feature worth illustrating here is the ability to highlight Sectors and Industries within larger indexes.
The following chart is of the Nasdaq 100. Stocks that fall within the Health Care Sector have been highlighted in dark blue. Then within that group we have highlighted only those stocks which fall within the Major Pharmaceuticals Industry in turquoise.
Knowing how the positions in your portfolio relate to each other and to the market as a whole has several benefits including:
- Lowering your portfolio risk
- Efficient use of capital
- The opportunity to hedge positions across different clusters of the market
- The ability to analyze hundreds of stocks simultaneously
- Highlighting your portfolio within the broader market to ensure you are not over exposed in any area
Our cluster analysis tool provides several features including:
- Sector highlighting
- Industry highlighting
- Cluster strength (ie: identify where clusters / herds of the market begin and end)
- Portfolio highlighting (ie: highlight your positions within Sector / Industry / Index charts to understand where it fits into the broader market)
- Interactive zoom and chart panning
All our cluster charts are updated daily to reflect the most recent activity in the stock market.
Being overly exposed and at risk to specific areas of the market is a surprisingly easy thing to do. Relationships exist between stocks that typically go unnoticed, but which have very real impacts on the profitability of your portfolio.
Having the ability to analyze the inherent herding behaviour of the stock market is an incredibly powerful tool both in terms of risk reduction and portfolio profitability.
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DiversifyPortfolio does not make trading or investing recommendations. This article, as well as all the content and analysis tools on DiversifyPortfolio are published as a research and informational service. Please refer to our Disclaimer.
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