Correlation
Quick Definition
A statistical measure ranging from -1 to +1 that describes how two investments move in relation to each other.
What Is Correlation?
Correlation measures the degree to which two assets move together. It's fundamental to portfolio construction and diversification.
Correlation Scale:
| Value | Meaning | Example |
|---|---|---|
| +1.0 | Perfect positive — move together | S&P 500 and large-cap ETF |
| +0.5 | Moderate positive | US stocks and developed market stocks |
| 0.0 | No relationship | Gold and tech stocks (historically) |
| -0.5 | Moderate negative | Stocks and long-term Treasuries |
| -1.0 | Perfect negative — move opposite | Long stock vs short stock |
Key Correlation Pairs:
| Asset Pair | Typical Correlation | Diversification Benefit |
|---|---|---|
| US Stocks / Int'l Stocks | +0.7 to +0.85 | Low |
| Stocks / Bonds | -0.2 to +0.3 | Moderate to High |
| Stocks / Gold | -0.1 to +0.2 | Moderate |
| Stocks / Real Estate | +0.5 to +0.7 | Low to Moderate |
| Stocks / Commodities | +0.1 to +0.4 | Moderate |
Why Correlation Matters:
- Low/negative correlation between assets = better diversification
- During crises, correlations often increase (everything falls together)
- The optimal portfolio combines assets with the lowest correlations
Correlation vs. Causation: Correlation does not imply causation. Two assets may move together without one causing the other's movement.
Rolling Correlation: Correlations change over time. The stock-bond correlation was positive in the 1970s-1990s but turned negative after 2000. Always use rolling windows rather than long-term averages.
Formula
Formula
ρ(X,Y) = Cov(X,Y) / (σX × σY)Correlation Example
- 1Stocks and bonds had a correlation of about -0.3 from 2000-2021, making them excellent diversifiers
- 2During the 2008 crisis, correlations spiked to +0.9 across most asset classes — diversification failed temporarily
Related Terms
Correlation
A statistical measure (-1 to +1) showing how two investments move relative to each other, crucial for diversification.
Covariance
A statistical measure indicating the directional relationship between two asset returns — positive when they move together, negative when they move oppositely.
Diversification
Spreading investments across various assets, sectors, and geographies to reduce risk without sacrificing expected returns.
R-Squared
A statistical measure (0-100%) indicating how much of a portfolio's performance can be explained by movements in its benchmark index.
Standard Deviation
A statistical measure of how spread out returns are from the average, quantifying investment volatility and risk.
Risk Management
The systematic process of identifying, assessing, and mitigating financial risks to protect portfolio value and achieve investment objectives.
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