60-second
Jargon Buster
Correlation
Just as with the word’s general usage, correlation in investment management is about themutual relationship between two or more things – namely, how asset classes or securities (tradeable financial assets) move in value in relation to each other.
If two asset classes or securities are highly correlated they tend perform similarly, moving up and down in value in the same way, while those with a low correlation behave in different ways. A correlation of 0 means there is little discernible relationship; +1 means they are perfectly correlated and moving in unison; and -1 means they move in exactly opposite directions. The correlation coefficient is always between -1.0 and +1.0, with those of +/- .2 or lower indicating that the positive or negative relationship is very weak, while a correlation coefficient of +/- .8 can be considered very strong.
Investors should care about correlation because of its role in managing risk and maximising returns. If all your investments are highly positively correlated, then it might be that an external factor, like a geopolitical shock event, an interest rate rise or a change in investor sentiment, will make them all lose value at the same time.
In contrast, having a selection of investments with low or negative correlations should grant a “buffer”, whereby some hold will their value or go up while the others go down. Spotting that your investments are more highly correlated than is ideal and adding those which have lower correlation is key to diversification. For instance, gold and other “safe haven” assets tend to be negatively correlated to risk assets like equities.
Correlation can also be useful in assessing whether a particular stock is performing well. If the one you hold is negatively correlated to similar ones in that sector, and does not rise as its peers do, then further investigation is warranted to assess its fundamentals.
- Correlation measures how asset classes or individual securities move in value relative to each other
- Correlation coefficients are measured between -1 and +1 to indicate either a negative or positive relationship
- Paying heed to correlations is a key part of diversification and thus managing your portfolio’s risk profile
Assessing the extent to which the asset classes, and individual securities, within a portfolio (or fund) are correlated predicts how likely they are to move in lock-step and therefore if the investor is doubling up on the
risk of their investments losing value at the same time. Implementing negatively correlated investments will help smooth returns and dial down risk. Remember, however, that correlation tells us only about association rather than causation and is thus an imperfect predictive tool taken alone.