DEFINITION of 'Cluster Analysis'

Cluster analysis is a technique used to group sets of objects that share similar characteristics. It is common in statistics, but investors will use the approach to build a diversified portfolio. Stocks that exhibit high correlations in returns fall into one basket, those slightly less correlated in another, and so on, until each stock is placed into a category.

If done correctly, the different clusters will exhibit minimal correlation from one another. This way investors gain all the virtues of diversification: reduced downside losses, capital preservation, and the ability to make riskier trades without adding to the total risk. Diversification remains one of the central tenants of investing and cluster analysis is just one channel to achieving it. 

BREAKING DOWN 'Cluster Analysis'

Cluster analysis enables investors to eliminate overlap in their portfolio by identifying securities with related returns. For example, a portfolio of only technology stocks may seem safe and diversified on the surface, but when an event like the Dotcom Bubble strikes, the entire portfolio is vulnerable to significant losses.

Buying and clustering assets that fit different market segments is crucial to increase diversification and protect against systematic risks. The technique can also uncover certain categories of stocks like cyclical and growth stocks. These specific strategies fall under smart beta or factor investing umbrella. They attempt to capture better risk-adjusted returns from specific risk premiums like minimum volatility, growth, and momentum.

In some way, smart beta or factor investing embodies the concepts of grouping and categorization preached by cluster analysis. The logic of clustering on a single common behavior mirrors the basic methodology behind factor investing, which identifies stocks susceptible to similar systematic risks and share similar characteristics.

It's not always the case that assets in a cluster live in the same industry. Oftentimes, clusters hold stocks from multiple industries like technology and financials. 

Drawbacks of Cluster Analysis

An obvious drawback to cluster analysis is the level of overlap between clusters. Clusters close in distance, meaning a high correlation in returns, often share some similar risk factors. So a down day in one cluster could translate to an equally weak performance in another cluster. For this reason, investors should find and cluster stocks with a large distance between them. That way, the clusters are impacted by different market factors.

That said, broad market pullbacks like the 2008 Recession will throttle the entire portfolio regardless of its construction. Even the most diversified clusters would have trouble withstanding recessionary headwinds. Here, the best clustering can do is minimize the extreme downside losses.

RELATED TERMS
  1. Fibonacci Clusters

    Fibonacci clusters are technical indicators used to identify ...
  2. Diversification

    Diversification is the strategy of investing in a variety of ...
  3. External Economies Of Scale

    External economies of scale are the lowering of a firm's costs ...
  4. Speculative Stock

    A speculative stock is a stock with a high degree of risk, such ...
  5. Growth Firm

    A growth firm represents a company that continues to record faster ...
  6. Systematic Risk

    Systematic risk, also known as market risk, is risk inherent ...
Related Articles
  1. Financial Advisor

    4 Reasons Why Market Correlation Matters

    Learn about how correlation can be used to measure how broader markets move in relation to each other. See how correlation is used to manage risk.
  2. Trading

    How To Make The Most of Fibonacci Grids (VDSI, GLW)

    Build your Fibonacci skills by finding the longest price swing on your chart of interest and placing a grid over the trend. Repeat at shorter intervals.
  3. Investing

    How To Manage Portfolio Risk

    Follow these tips to successfully manage portfolio risk.
  4. Investing

    How to Diversify Your Portfolio Beyond Stocks

    Find out how to get diversified in asset classes beyond stocks to reduce portfolio risk. Learn how diversification can help you reach your financial goals.
  5. Trading

    Stop Hunting With the Big Forex Players

    Learn to bank short-term profits by placing stops away from the crowd.
  6. Financial Advisor

    Concentrated Vs. Diversified Portfolios: Comparing the Pros and Cons

    Examine the relative advantages and disadvantages of utilizing either a concentrated or a diversified investment portfolio strategy.
  7. Investing

    Understand Risk Before You Diversify

    Before investors can use diversification to maximize investment returns, they need to understand unsystematic risk and systematic risk.
RELATED FAQS
  1. How are negative correlations used in risk management?

    Learn about risk management and how negative correlations between assets are used to diversify and hedge risk associated ... Read Answer >>
  2. Is there a positive correlation between risk and return?

    Learn about the positive correlation between risk and the potential for return, and understand how risk is used to construct ... Read Answer >>
  3. How can you calculate correlation using Excel?

    Find out how to calculate the Pearson correlation coefficient between two data arrays in Microsoft Excel through the CORREL ... Read Answer >>
  4. How does correlation affect the stock market?

    Learn about the role correlation plays in prudent stock market investing, and how the correlation coefficient is used to ... Read Answer >>
Hot Definitions
  1. Socially Responsible Investment - SRI

    Socially responsible investing looks for investments that are considered socially conscious because of the nature of the ...
  2. Business Cycle

    The business cycle describes the rise and fall in production output of goods and services in an economy. Business cycles ...
  3. Futures Contract

    An agreement to buy or sell the underlying commodity or asset at a specific price at a future date.
  4. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  5. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  6. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
Trading Center