Weighing up your investment risks: The ins and outs of correlation

Julie Brownlee, Fsp Invest, 05 Oct. 2015

Tags: correlation, what is correlation, correlation and investing, risk, volatility, portfolio management,

If you’ve read anything about investment risk, you’ll likely have come across the term ‘correlation’.

To spread your risk, it’s a good idea to spread your investments across investments that aren’t highly correlated to one another.

Let’s take a closer look at correlation and what it means for you…

What is correlation?

Correlation is a statistical measurement. It looks at how closely two things move together over time.

When it comes to investing, correlation is about the relationship between different asset classes or securities.

Here’s how it works…

If you have two shares that are positively correlated, their prices move in a similar way. On the other hand, if you have two shares that are negatively correlated, their prices tend to move in opposite directions.

Delving into correlation

To get more technical, you measure correlation with the correlation coefficient. This is a number between +1 and -1.

If you have a correlation coefficient of +1, there is perfect correlation. If you have a correlation coefficient of -1, there is perfect negative correlation. And a correlation coefficient of 0 means there’s no consistent relationship.

How to use correlation

Professional investors may keep an eye on correlations to help them manage risk. They select different investments that are not all positively correlated. This should help to lower their overall volatility.

But correlations are not set in stone. Take stocks and bonds. Historically, bonds have fallen as stocks have risen, but over recent years, they’ve become more aligned.

Also when markets are in turmoil, correlations can skew.

So there you have it. The ins and outs of correlation.

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