Correlation Matrix : 14 Moat Stocks Vs SPY

Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other.

Correlation shows the strength of a relationship between two variables and is expressed numerically by the correlation coefficient. The correlation coefficient’s values range between -1.0 and 1.0.

A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation, -1, means that two assets move in opposite directions, while a zero correlation implies no linear relationship at all.

Negative correlations of investments are used with portfolio risk management to decide how to allocate assets. Portfolio managers and investors believe that some of the risk associated with the portfolio would be diversified if they can assemble a portfolio of negatively correlated assets. The strategy of assembling negatively correlated assets might be appropriate, for example, if a portfolio manager is forecasting a market crash or in times of high volatility and combine assets to produce a low volatility portfolio. Using negatively correlated investments helps to reduce the overall volatility of the portfolio.

Investors who wish to mitigate risk can do so by investing in non-correlated assets

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.

Last important point : Correlation is not a static value; it evolves over time. Regularly assessing and updating correlation matrices can help in identifying potential issue and adapting strategies accordingly. A lack of monitoring can lead to underestimating the risks and the potential impact on the portfolio.

Now let’s look at a real application . I have randomly selected 14 stocks endowed with solid competitive advantages or Moat as Buffet calls them.

Let’s see them graphically .

Correlation is just one of many tools available to the investor and is used to examine the diversification risk of one’s portfolio.

As always, it is necessary to conduct further research and make appropriate assessments before committing your capital.