What Is Correlation?
In statistics, correlation measures the degree to which two (or more) variables move together. Positive correlation values indicate movement together in the same direction. Negative correlation values indicate movement in opposite directions. Correlation values range from -1.0 to +1.0, with a value of 0 indicating no relationship between the variables.
In finance and financial markets, correlation measures the relationship between two securities (stocks, bonds, ETFs, mutual funds, indexes, etc.) and the degree to which they move together. Securities with high positive correlation values move together in the same direction. Securities with high negative correlation values move in exactly opposite directions. Securities with very low correlation values (at or around 0) are unrelated with respect to the directions in which they move.
Why Use Correlation?
A well-diversified portfolio can be built using correlation values, which lowers risk and increases returns. You can restrict risk by lowering your exposure to individual market shocks by assembling a portfolio that includes a variety of assets from several asset classes, all of which have low correlation values.
How To Use Correlation
In order to take advantage of correlation, you should balance the securities in your portfolio based on their correlation values, making sure that they are not all concentrated in a certain range when compared to a common benchmark, like the S&P 500.
It can be demonstrated that the assets in your portfolio move in very similar directions, increasing your risk exposure to individual market shocks, for instance, if you have ten stocks and funds with correlation values against the S&P 500 that range from +0.87 to +0.98.
However, if your portfolio’s stocks and funds are more varied and the correlation values fall between, say, -0.79 and +0.95, your portfolio can be regarded as more widely diversified and, hence, less vulnerable to singular market shocks.
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