Here’s a commentary by Cormac Mullen of Bloomberg News on September 14, 2017 about “cluster” risk:
“Cluster risk, occurring when performance patterns become correlated among a group of stocks with similar business profiles yet different sector classifications, is a hazard that can often slip under a risk manager’s radar, AB’s David Dalgas, Klaus Ingemann and Thomas Christensen wrote in a blog post.”
“Facebook Inc., Amazon.com Inc., Apple Inc., Netflix Inc. and Google owner Alphabet Inc. — collectively known as the FAANGs — are a prime example, AB said. Together the mega-cap stocks accounted for more than a quarter of the gains in the S&P 500 from the beginning of the year through August and have become increasingly correlated.”
The danger of this correlation risk is when the market falls, this group will fall together with similar losses. It’s also like owning all the Canadian bank stocks.
The moral of the story is to buy one but not all the FAANG stocks or Canadian banks. Most do-it-yourself investors and even some professionals fail to protect their overall portfolio risk by owning stocks that are similar in nature to each other.
It’s better to have a compilation of names that are in different industries, different countries and are of a different size. This diversification should help protect the risk of a big loss. After all, investing is not about how much you make but how much you avoid losing. It’s the latter statement that keeps you in the game for the long term.