Sector similarities in macro point 1 (Interactive Financial Analysis)
Nov 7, 2021 #IFA0001
One of the most common things we hear as advice of investment is that we must distribute money over various kinds of companies/ETFs for safety. If money is well distributed, we won’t lose much even if one or two companies fail.
Definition of Diversification (investpedia.com)
What Is a Diversified Portfolio? (thebalance.com)
Diversification (Wikipedia)
But the problem of such diversified investment is about how to distribute money. There are several methods of diversification like foreign diversification. It’s a good manner to invest money on companies of several countries. But when we choose companies, we should pay attention to their similarities, because investing money on similar companies often doesn’t lead to a good diversification. Since it’s not easy to evaluate similarities of every pair of companies, in this article we’re going to see similarities of sectors instead.
Evaluation of sector similarity
Sector similarities are evaluated by comparing price performances of sectors for over 5 years. The performance of sectors is the price change average weighted by market caps. That is, largest companies in a sector have largest influence on the performance of sector.
Most similar sectors
The first thing we notice is that the pair of “Industrial Products” and “Transportation” has the largest similarity score 22.7. The shapes of performance chart are most similar than other pairs of sectors especially during the pre-pandemic period.
“Industrial Products” is a sector that mainly makes capital products that are used in construction, manufacturing, and resource extraction, while the sector “Transportation” is made up of companies such as railroads, airlines, trucking companies, and marine shipping.
We don’t know exactly what’s behind the similarity of these sectors, but we can expect that it may be because goods made by “Industrial Products” are shipped by “Transportation”, and thus, they have the largest similarity in price performance.
The second largest similarity of sectors are held by “Basic Materials” and “Industrial Products”. It’s not that difficult to predict that the similarity is because goods made by “Industrial Products” are made of materials produced by companies that belong to “Basic Materials”.
This easily leads to another expectation that “Basic Materials” and “Transportation” have large similarity as well. This means that the three sectors are highly codependent in business in a way that “Transportation” ships products made by “Industrial Products”, and these products are made of raw materials produced by “Basic Materials”.
Regardless of what’s causing these similarities, we should not invest on these sectors at the same time if we want to make a diversified investment, because if the performance of one of these sectors drops, it would be highly possible that the other two sectors would drop as well.
Our website provides the whole view of sector similarities with interactive data. You can also find unsimilar sectors as well. Please check it!
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