A:

The correlation coefficient is a measure that determines the degree to which two variables' movements are associated. The most common correlation coefficient, generated by the Pearson product-moment correlation, may be 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 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 whereby a correlation of -1.0 indicates a perfect negative correlation, and a correlation of 1.0 indicates a perfect positive correlation. Anytime the correlation coefficient, denoted as r, is greater than zero, it's a positive relationship. Conversely, anytime the value is less than zero, it's a negative relationship. A value of zero indicates that there is no relationship between the two variables.

In the financial markets, correlation coefficient is used to measure the correlation between two securities. When two stocks, for example, 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, it signifies that 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 r 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. For example, suppose the prices of coffee and of computers are observed and found to have a correlation of +.0008; this means that there is no correlation, or relationship, between the two variables.

Positive Correlation

A positive correlation, when the correlation coefficient (r) is greater than 0, signifies that both variables move in the same direction or are correlated. When r 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 r is to +1, the stronger the linear relationship. For example, suppose the value of oil prices are directly related to the prices of airplane tickets, with a correlation coefficient of +0.8. 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 follow in tandem. If the price of oil increases, so does 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). As you can imagine J.P. Morgan 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 .7919, which is close to signaling a strong positive correlation. A reading above .50 typically signals a strong positive correlation.

Understanding the correlation between two stocks or a 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 ETFs can be compared with the correlation coefficient. 

Negative Correlation

A negative correlation occurs when the correlation coefficient (r) is less than 0 and indicates 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 r is -1, the relationship is said to be perfectly negative 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 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, negative correlation doesn't 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.  

The Bottom Line

The correlation coefficient can be helpful in determining the relationship between your investment and the overall market or other securities.

This type of statistic is useful in many ways in finance. 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 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.

Do you know why correlation matters for investing? Read "4 Reasons Why Market Correlation Matters."

RELATED FAQS
  1. What is the difference between a copay and a deductible?

    Learn how the correlation coefficient may be used to predict the relationship between the returns of two stocks, but also ... Read Answer >>
  2. How does correlation affect the stock market?

    Learn about the role correlation plays in prudent stock market investing, and how the correlation coefficient is used to ... Read Answer >>
  3. Does a negative correlation between two stocks mean anything?

    Learn what the concept of negative correlation means, understand how it is generally calculated and see how it is used in ... Read Answer >>
  4. What is the correlation between U.S. stock prices and the value of the U.S. dollar?

    The correlation between American stock prices and the U.S. dollar comes down to the two variables having a correlation coefficient ... Read Answer >>
  5. How is correlation used in modern portfolio theory?

    Discover how modern portfolio theory and the efficient frontier use correlation between investment assets to predict an optimal ... Read Answer >>
  6. How do investment advisors calculate how much diversification their portfolios need?

    Learn how modern portfolio theory (MPT) can help determine a diversified mix of assets for inclusion in a portfolio that ... Read Answer >>
Related Articles
  1. Investing

    What's the Correlation Coefficient?

    The correlation coefficient is a measure of how closely two variables move in relation to one another. If one variable goes up by a certain amount, the correlation coefficient indicates which ...
  2. Insights

    Prices of Stocks and Bonds Move More in Tandem

    Correlation between stock and bond prices in the U.S. have reached a 10-year high, reversing a broader trend of negative correlation.
  3. Investing

    How To Trade Currency And Commodity Correlations

    Relationships between currencies and commodities exist throughout the financial markets. Find out how to trade these trends.
  4. Investing

    How does crude oil affect gas prices?

    Understand the origins of oil, how its price is determined and where its correlation with gas prices falls in the global economy.
  5. Investing

    The Market Is Assessing Trump Implications

    Stocks are no longer moving in unison, and active fund managers are cheering.
  6. Investing

    Do Oil and Natural Gas Prices Rise And Fall Together?

    Do the prices of crude oil and natural gas affect each other? Investopedia explores price patterns and provides analysis.
  7. Investing

    How to Diversify Your Portfolio Beyond Stocks

    Find out how to get diversified in asset classes beyond stocks to reduce portfolio risk. Learn how diversification can help you reach your financial goals.
  8. Investing

    How to Create a Risk Parity Portfolio

    Learn about how risk parity uses leverage to create equal exposure to risk among different asset classes in portfolio construction.
RELATED TERMS
  1. Correlation Coefficient

    The correlation coefficient is a statistical measure that calculates ...
  2. Negative Correlation

    A perfect negative correlation is a relationship between two ...
  3. Coefficient of Determination

    The coefficient of determination is a measure used in statistical ...
  4. Inverse Correlation

    An inverse correlation, also known as negative correlation, is ...
  5. Coefficient of Variation (CV)

    Coefficient of variation (CV) is a measure of the dispersion ...
  6. Multiple Linear Regression - MLR

    Multiple linear regression (MLR) is a statistical technique that ...
Hot Definitions
  1. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  2. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  3. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  4. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  5. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
  6. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained in a company’s financial statements.
Trading Center