In finance, correlation measures how two securities move in relation to each other.
When the prices of two securities move in a similar fashion, the securities are considered correlated. This is measured between 0 (no correlation) and +1 (perfect correlation). A perfect correlation means the relationship between two securities is perfect all of the time. The closer to +1 the stronger the relationship is.
When two securities move in opposite directions, they are considered negatively correlated. This is measured between 0 and -1 (perfect negative correlation). A perfect negative correlation shows that the relationship between two securities is perfectly opposite all of the time. The closer to -1, the stronger this relationship is.
When the correlation is equal to 0, there is no relationship between how the two securities’ prices move.
The formula for correlation is as follows:
Why Correlation is Important for Portfolio Diversification
It is considered dangerous to have a portfolio of correlating assets. Too much of the same kind of asset means that when the market cools for that asset, the entire portfolio is at risk.
For example, if someone owns shopping malls and smaller retail properties, one might assume these have some sort of correlation with each other. This puts the investor’s portfolio at risk if anything threatens the retail industry — such as a pandemic.
Correlation can also be used to forecast future trends as a way to control portfolio risk. If two securities move positively together with one lagging behind, an investor could use the security that is ahead to predict the second security’s price.