Correlation, by itself, cannot affect the stock market because it is simply the degree to which two things behave in the same way. However, the correlation between the activity of two stocks, or between a stock and the performance of a given index, sector or industry, can be a very important factor in developing a prudent investing strategy. Stock analysts use a measure called the correlation coefficient to make predictions about how a stock will behave based on past performance and the activity of another security with which the stock in question has been shown to correlate.
What Is the Correlation Coefficient?
The correlation coefficient is used to measure both the degree and direction of the correlation between any two stocks. It can be anywhere between -1 and 1, though it is almost always in between. Any two securities that have a coefficient of 1 are said to be "perfectly" correlated. This means when one stock moves up five points, the other does exactly the same thing, at the same time. A correlation of -1 is a "perfect" negative correlation, meaning that when one stock goes up five points, the other loses five points. This kind of behavior is incredibly rare in the stock market, so perfect correlations are almost entirely theoretical.
How and Why Do Stocks Correlate?
Most stocks have a correlation somewhere in the middle of the range, with a coefficient of 0 indicating no relationship whatsoever between the two securities. A stock in the online retail space, for example, likely has no correlation with the stock of a tire and auto body shop. This is because the businesses have very different operations, and the products and services of the auto shop are not things that can be provided virtually.
A brick-and-mortar book retailer, however, likely has a negative correlation with the stock of Amazon.com, as the online retailer's popularity is typically bad news for traditional book stores. The stock of the popular payment processor PayPal is likely to be positively correlated with the stocks of online retailers that use its services. If the stocks of eBay, Amazon and Best Buy pick up due to increased online revenue, it is likely that PayPal will experience a similar boost as its fee-driven income picks up and positive earnings reports encourage investors.
Using the Correlation Coefficient
When developing an investment strategy and selecting stocks for your portfolio, the correlation coefficient can be a very helpful tool. It can be used to select stocks in different industries that tend to move in tandem, or to hedge your bets by selecting stocks with a negative coefficient so that if one stock fails, the other is likely to get a boost. When stocks have a correlation coefficient of 0, it does not mean they never behave in the same way; rather, it means that they are as likely to move differently as they are to move together, making them unpredictable. However, this also means there is less likelihood that many noncorrelated stocks will fail simultaneously.
Choosing a variety of stocks with different degrees and directions of correlation is one of the most common and effective diversification strategies. The result is a portfolio that displays a general upward trend, since, at any given time, at least one security should be doing well even if others are failing.