In finance and investment industries; correlation coefficient is a statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management and computed as the correlation coefficient; which has a value that must fall between -1.0 and +1.0.
What is Correlation Coefficient?
Correlation shows the strength of a relationship between two variables and is expressed numerically by the correlation coefficient. The correlation coefficient’s values range between -1.0 and 1.0.
- Correlation is a statistic that measures the degree to which two variables move in relation to each other.
- In finance, the correlation can measure the movement of a stock with that of a benchmark index, such as the S&P 500.
- Correlation is closely tied to diversification, the concept that certain types of risk can be mitigated by investing in assets that are not correlated.
- Correlation measures association, but doesn’t show if x causes y or vice versa—or if the association is caused by a third factor.
- Correlation may be easiest to identify using a scatterplot, especially if the variables have a non-linear yet still strong correlation.
Understanding Correlation Coefficient
A correlation coefficient is a statistical measure of the degree to which changes to the value of one variable predict changes to the value of another. In positively correlated variables, the value increases or decreases in tandem. In negatively correlated variables, the value of one increases as the value of the other decreases.
A perfect positive correlation means the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction.
A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no linear relationship at all.
Correlation and Portfolio Diversification
In investing, correlation is most important in relation to a diversified portfolio. Investors who wish to mitigate risk can do so by investing in non-correlated assets.
For example, consider an investor who owns airline stock. If the airline industry is found to have a low correlation to the social media industry, the investor may choose to invest in a social media stock understanding that a negative impact on one industry may not impact the other.
This is often the approach when considering investing across asset classes.
Stocks, bonds, precious metals, real estate, cryptocurrency, commodities, and other types of investments each have different relationships with each other.
While some may be heavily correlated, others may act as a hedge to diversify risk if they are not correlated.
Note: Risk that can be diversified away is called unsystematic risk. This type of risk is specific to a company, industry, or asset class. Investing in different assets can reduce your portfolio’s correlation and reduce your exposure to unsystematic risk.
For more, read: Systematic risk VS Unsystematic risk | Key Difference
Why Correlation Coefficient is Important in Finance?
Correlations play an important role in finance because they are used to forecast future trends and to manage the risks within a portfolio.
These days, the correlations between assets can be easily calculated using various software programs and online services.
Correlations, along with other statistical concepts, play an important role in the creation and pricing of derivatives and other complex financial instruments.
Example of Correlation Uses
Correlation is a widely-used concept in modern finance. For example, a trader might use historical correlations to predict whether a company’s shares will rise or fall in response to a change in interest rates or commodity prices.
Similarly, a portfolio manager might aim to reduce their risk by ensuring that the individual assets within their portfolio are not overly correlated with one another.
Is High Correlation Better?
Investors may have a preference for the level of correlation within their portfolio. In general, most investors will prefer to have a lower correlation as this mitigates risk in their portfolios of different assets or securities being impacted by similar market conditions.
However, risk-seeking investors or investors wanting to put their money into a very specific type of sector or company may be willing to have higher correlation within their portfolio in exchange for greater potential returns.