Correlation

what is simple correlation

In the world of finance, correlation is a statistical measure of how two securities move in relation to each other.

Correlation is represented by the "correlation coefficient", which ranges between -1 and +1.

When the prices of two securities usually move in a similar direction, the securities are considered "correlated."  The amount of correlation ranges from 0, which means no correlation, to 1, which means perfect correlation. Perfect correlation means the relationship that appears to exist between two securities is positive 100% of the time.

For example, if the price of oil related stocks increases while gas related stocks tend to increase as well, they are considered to have a positive correlation. The more predictably they do this, the closer the correlation coefficient is to +1 .

On the other extreme, when the prices of two securities consistently move

in opposite  directions, they are negatively  correlated. This is measured from 0 to -1, where zero is no correlation, and negative 1 is perfect negative correlation. A perfect negative correlation means that the relationship between two securities is opposite 100% of the time.

For example, if the price of small cap stocks increases while government bonds tend to decrease, they have a negative  correlation. The more predictably they do this, the closer the correlation coefficient is to -1 .

"No-correlation" securities move independently of each other, with no apparent relationship. If the price of oil related stocks and medical related stocks move independently of each other, they have 0 (or no) correlation.

No-correlation is important for portfolio diversification. When some securities in a portfolio are losing money, other non-correlated securities will likely still be gaining or not moving at all, reducing the investor's losses.

Source: www.investopedia.com

Category: Forex

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