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What Is Correlation?

In investing, correlation describes how investments move relative to each other. Positively correlated assets move in the same direction, while negatively correlated assets move in opposite directions. The more correlated two assets are, the more risk they can potentially bring to your portfolio.

Correlation, explained

Correlation measures the degree to which two securities move compared to each other.

You can analyze correlation using two assets’ correlation coefficient, which ranges from -1.0 to +1.0. (We won’t go into the math here; however, you can look up coefficients or calculate them yourself.)

If two assets have a correlation of +1.0, they have a perfect positive correlation and move in lockstep. Assets with a correlation of -1.0 have a perfect negative correlation and move in exactly opposite directions. Securities with a score of 0 are non-correlated – that is, their price movements are unrelated.

The correlation coefficient helps measure the strength of two assets’ correlation. For instance, a score of 0.2 shows some positive correlation, while -0.2 indicates a slight negative correlation.

How does correlation affect you?

Modern portfolio theory holds that investing in non-correlated assets reduces portfolio risk. Owning assets that move in different directions in response to the same stimuli can:

• Prevent you from seeing portfolio-wide climbs and dips
• Minimize extreme losses (at the risk of tempering extreme gains)
• Generate greater long-term returns

Generally, correlation remains a useful data point for investors. However, it’s important to note that many assets share more correlation than they did 20 years ago.

For example, while bonds use to move opposite stocks more of the time, they often move together today. The same is true of international and U.S. stocks, which may respond more similarly to economic events than they did in the 1990s.

This reality makes “true” non-correlation rarer than it used to be. Still, the less correlated your portfolio assets are, the more risk mitigation you’ll enjoy.

Diversifying your investments is one of the best ways to reduce portfolio correlation. Holding cash, stocks, bonds, real estate and commodities, investing across industries and branching out across market caps can all reduce correlation. The more diversification you have, the less likely your assets will move together in response to stimuli.

While diversification can’t remove correlation entirely – nor would you want to – investing in a wide “basket” of securities dampens your portfolio’s overall volatility. And introducing more non-correlated assets can act as a hedge against market risk.

What this means for you

Every investor has their own preference and risk tolerance for investment correlation. For some, low correlation mitigates the risk that your investments will all see losses at the same time. For others, higher correlation brings in more risk with the potential for greater returns.

Fortunately, Q.ai makes investing in your preferred level of correlation a cinch. We crunch the numbers in all our correlated and non-correlated Investment Kits so you don’t have to, from Gas Spike and Tech Rally to Bond Spread and U.S. Outperformance.

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