(investopedia.com) – Correlation coefficients are indicators of the strength of the relationship between two different variables. A correlation coefficient that is greater than zero indicates a positive relationship between two variables. A value that is less than zero signifies a negative relationship between two variables. Finally, a value of zero indicates no relationship between the two variables that are being compared.
- Correlation coefficients are used to measure the strength of the relationship between two variables.
- A correlation coefficient greater than zero indicates a positive relationship while a value less than zero signifies a negative relationship
- A value of zero indicates no relationship between the two variables being compared.
- A negative correlation, or inverse correlation, is a key concept in the creation of diversified portfolios that can better withstand portfolio volatility.
The correlation coefficient (ρ) is a measure that determines the degree to which the movement of two different variables is associated. The most common correlation coefficient, generated by the Pearson product-moment correlation, is used to measure the linear relationship between two variables. However, in a non-linear relationship, this correlation coefficient may not always be a suitable measure of dependence.
The possible range of values for the correlation coefficient is -1.0 to 1.0. In other words, the values cannot exceed 1.0 or be less than -1.0. A correlation of -1.0 indicates a perfect negative correlation, and a correlation of 1.0 indicates a perfect positive correlation. If the correlation coefficient is greater than zero, it is a positive relationship. Conversely, if the value is less than zero, it is a negative relationship. A value of zero indicates that there is no relationship between the two variables.
Correlation among variables does not (necessarily) imply causation.
In the financial markets, the correlation coefficient is used to measure the correlation between two securities. For example, when two stocks move in the same direction, the correlation coefficient is positive. Conversely, when two stocks move in opposite directions, the correlation coefficient is negative.
If the correlation coefficient of two variables is zero, there is no linear relationship between the variables. However, this is only for a linear relationship. It is possible that the variables have a strong curvilinear relationship. When the value of ρ is close to zero, generally between -0.1 and +0.1, the variables are said to have no linear relationship (or a very weak linear relationship).https://8bee0d9e73b1d8ffec3cd5233c97979f.safeframe.googlesyndication.com/safeframe/1-0-37/html/container.html
For example, suppose that the prices of coffee and computers are observed and found to have a correlation of +.0008. This means that there is no correlation, or relationship, between the two variables.https://8bee0d9e73b1d8ffec3cd5233c97979f.safeframe.googlesyndication.com/safeframe/1-0-37/html/container.html
The covariance of the two variables in question must be calculated before the correlation can be determined . Next, each variable’s standard deviation is required The correlation coefficient is determined by dividing the covariance by the product of the two variables’ standard deviations.
Standard deviation is a measure of the dispersion of data from its average. Covariance is a measure of how two variables change together. However, its magnitude is unbounded, so it is difficult to interpret. The normalized version of the statistic is calculated by dividing covariance by the product of the two standard deviations. This is the correlation coefficient.
A positive correlation—when the correlation coefficient is greater than 0—signifies that both variables move in the same direction. When ρ is +1, it signifies that the two variables being compared have a perfect positive relationship; when one variable moves higher or lower, the other variable moves in the same direction with the same magnitude.
The closer the value of ρ is to +1, the stronger the linear relationship. For example, suppose the value of oil prices is directly related to the prices of airplane tickets, with a correlation coefficient of +0.95. The relationship between oil prices and airfares has a very strong positive correlation since the value is close to +1. So, if the price of oil decreases, airfares also decrease, and if the price of oil increases, so do the prices of airplane tickets.
In the chart below, we compare one of the largest U.S. banks, JPMorgan Chase & Co. (JPM), with the Financial Select SPDR ETF (XLF).1 2 As you can imagine, JPMorgan Chase & Co. should have a positive correlation to the banking industry as a whole. We can see the correlation coefficient (bottom of the chart) is currently at 0.97, which is signaling a strong positive correlation. A reading above 0.50 typically signals a positive correlation.
Understanding the correlation between two stocks (or a single stock) and its industry can help investors gauge how the stock is trading relative to its peers. All types of securities, including bonds, sectors, and exchange-traded funds (ETFs) can be compared with the correlation coefficient.
A negative (inverse) correlation occurs when the correlation coefficient is less than 0. This is an indication that both variables move in the opposite direction. In short, any reading between 0 and -1 means that the two securities move in opposite directions. When ρ is -1, the relationship is said to be perfectly negatively correlated. In short, if one variable increases, the other variable decreases with the same magnitude (and vice versa). However, the degree to which two securities are negatively correlated might vary over time (and they are almost never exactly correlated all the time).
For example, suppose a study is conducted to assess the relationship between outside temperature and heating bills. The study concludes that there is a negative correlation between the prices of heating bills and the outdoor temperature. The correlation coefficient is calculated to be -0.96. This strong negative correlation signifies that as the temperature decreases outside, the prices of heating bills increase (and vice versa).
When it comes to investing, a negative correlation does not necessarily mean that the securities should be avoided. The correlation coefficient can help investors diversify their portfolio by including a mix of investments that have a negative, or low, correlation to the stock market. In short, when reducing volatility risk in a portfolio, sometimes opposites do attract.
For example, assume you have a $100,000 balanced portfolio that is invested 60% in stocks and 40% in bonds. In a year of strong economic performance, the stock component of your portfolio might generate a return of 12% while the bond component may return -2% because interest rates are rising (which means that bond prices are falling). Thus, the overall return on your portfolio would be 6.4% ((12% x 0.6) + (-2% x 0.4). The following year, as the economy slows markedly and interest rates are lowered, your stock portfolio might generate -5% while your bond portfolio may return 8%, giving you an overall portfolio return of 0.2%.
What if, instead of a balanced portfolio, your portfolio was 100% equities? Using the same return assumptions, your all-equity portfolio would have a return of 12% in the first year and -5% in the second year. These figures are clearly more volatile than the balanced portfolio’s returns of 6.4% and 0.2%.
The Bottom Line
The correlation coefficient can be helpful in determining the relationship between an investment and the overall market or other securities. This statistical measurement is useful in many ways, particularly in the finance industry. For example, it can be helpful in determining how well a mutual fund is behaving compared to its benchmark index, or it can be used to determine how a mutual fund behaves in relation to another fund or asset class. By adding a low, or negatively correlated, mutual fund to an existing portfolio, diversification benefits are gained.
Compete Risk Free with $100,000 in Virtual Cash
Put your trading skills to the test with our FREE Stock Simulator. Compete with thousands of Investopedia traders and trade your way to the top! Submit trades in a virtual environment before you start risking your own money. Practice trading strategies so that when you’re ready to enter the real market, you’ve had the practice you need. Try our Stock Simulator today >>