Diversification should play an important role in any investor's strategy. But simply buying stocks from other industries isn't necessarily a guaranteed way to protect yourself from a market crash or downturn. American Airlines and Royal Caribbean are technically in different industries, but they're both struggling due to the pandemic and are down more than 30% over the past year (while the S&P 500 has risen 16%). Holding both stocks in your portfolio would effectively compound your risk.
That's why simply selecting stocks from other industries is not enough. Investors should also consider how closely correlated stocks are. A correlation shows the relationship between values and how they move together. For stocks, it's important because you can use correlations to help predict whether two or more investments might move in the same direction.
Investing in uncorrelated stocks gives you much better diversification
Calculating correlations can be a time-consuming activity, but just looking at stock charts can give you a quick glimpse as to how closely one follows another. Here's how two top marijuana stocks, Aurora Cannabis (ACB 7.75%) and Canopy Growth (CGC 4.72%), have moved over the past three years:
The two stocks do not move dollar for dollar in the same direction, but they do follow a very similar path -- although Aurora Cannabis has failed to replicate Canopy Growth's recent spike after the company's CEO made a shocking and bullish prediction suggesting it could soon be operating in the U.S. market. Company-specific factors can disrupt these correlations, but generally, investors can expect to see cannabis producers Canopy Growth and Aurora Cannabis move in fairly similar directions, as they will both benefit from the same industry-specific trends. Investing in both of these stocks can amplify your returns when times are good and there's a lot of bullishness surrounding the cannabis industry. But when the outlook isn't so good, holding both of these stocks can compound your losses and put you in a bigger hole.
A good option if you invest in one of these stocks can be to add a more conservative stock like Johnson & Johnson to your portfolio. The healthcare giant is not in cannabis, and a quick look at its stock performance shows that it hasn't moved in the same direction as either of those pot stocks:
Despite the volatility of both pot stocks, Johnson & Johnson's shares have grown steadily over the same time frame. This is an example of an uncorrelated stock and one that could be a great option for cannabis investors looking to diversify their investments. By holding Johnson & Johnson in your portfolio, you can earn good returns even as Canopy Growth and Aurora Cannabis shares fluctuate wildly.
But when looking at uncorrelated stocks, you also want to be careful not to become too aggressive and focus on the ones that are negatively correlated. That could prove disastrous for your portfolio.
Negatively correlated stocks could offset your gains
A negative correlation is when a stock moves in the opposite direction of a given investment. One example involves gold mining company Kirkland Lake. When investors look for safety as opposed to growth, they often turn to gold or gold stocks, which explains why Kirkland Lake and Canopy Growth have moved in opposite directions in recent years:
Investing in gold stocks can be a great way to gain exposure to the rising price of gold. But the danger with negatively correlated stocks is that they can offset one another's returns. If the price of one stock goes up, then a negatively correlated stock will go down, especially the greater the correlation is. While it might not be a bad idea to hold a few such investments if it is part of a broader strategy, this is an example where diversifying too much can bring down your portfolio's overall performance.
Aim for zero
If you're building your portfolio, look for stocks that do not have any correlation to one another, whether it is positive or negative. The lower the overall correlation, the more diversification you can achieve.
But it is important to remember that correlations can change, especially if a company enters another industry or takes on a new strategy. Many marijuana companies, for instance, are focusing more on the consumer packaged goods industry. And Jazz Pharmaceuticals recently acquired cannabis stock GW Pharmaceuticals, which will likely affect the strategy for both companies moving forward.
The bottom line is that investors will still need to continue to monitor their stocks if they want to avoid too much exposure to a segment of the market. But if you don't want to be bothered with worrying about whether stocks are correlated or not and whether your portfolio is diverse enough, you can always invest in an exchange-traded fund (ETF) that mirrors the S&P 500.