What is correlation?
Posted: Wed Dec 11, 2024 10:14 am
It can often be interesting to compare and measure the relationship between two numerical variables. The study of correlation is one of the most widely used techniques to predict the behavior of a variable based on the results of another.
Concept
Correlation is an association between two numerical variables that assesses the trend (increase or decrease) in the data .
When one variable gives us information about another variable, we say that the two variables are related. On the other hand, when there is no correlation, the increase or decrease of one variable tells us nothing about the behavior of another variable.
The concept of correlation is used in finance to describe the degree to which two assets tend to move in the same direction. Correlation is usually summarized as a number ranging from -1 to 1.
-1 means perfect negative correlation
0 means no correlation
1 means perfect positive correlation
Positively correlated assets tend to move in the same direction most of the time. Negatively correlated assets, on the other hand, tend to move in opposite directions.
Very rarely is the correlation perfectly positive gambling data indonesia phone number or negative; most of the time the correlation value lies somewhere between -1 and 1.
In 1952, Harry Markovitz , then a 25-year-old graduate student, published " Portfolio Selection ," a 14-page article that changed the history of finance and for which he was awarded the Nobel Prize in 1990.
Markovitz described in a mathematical formula the benefit in terms of risk /return of placing in a portfolio securities that move independently to a certain extent.
Common sense has always recognized the benefits of diversification , of not putting all your eggs in one basket. This was intuitively true in finance as well, but no theory had described it mathematically until then. Markovitz was the first to describe the benefit of diversification in a quantitative way.
The key is to find assets that move independently of each other to some extent. The lower the correlation between assets, the greater the benefits of diversification.
The greater the degree to which assets move independently, the lower the risk that the portfolio will experience large fluctuations in value.
As you can see, this concept, which may seem simply statistical, is widely used in the world of finance. It allows us to compare the movement of certain assets with respect to others. In fact, the analysis of the variation of an asset with respect to others is crucial for the construction of stock portfolios .
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Correlation in investment
Intuitively, a portfolio consisting of a number of assets that move up or down at the same time will be riskier than a portfolio in which some assets move up when others move down.
In the first case, the investor would have a positively correlated portfolio, so the total value of the investment is likely to fluctuate much more than the value of the second portfolio.
In the second case, however, the investor would have a portfolio with negative correlation, the gains obtained from the securities that rise will offset, at least partially, the losses from the securities that fall. Therefore, you will be investing with a higher degree of diversification than in the first case.
Typically, investors prefer limited fluctuations.
Examples of what asset correlation means in the real world
Let's look, for example, at the commodity price index (in red) and the value of the Australian dollar (in blue).
Australia is a producer of commodities (copper and iron ore in particular), so the value of its currency is likely to be influenced by fluctuations in the prices of such commodities.
The correlation between commodities and the Australian dollar
From the chart above, it is evident that they tend to move in a synchronized manner. In technical terms, we would say that they are positively correlated .
Previously, in the post why invest in gold we explained how gold and interest rates often tend to move in opposite directions.
In the chart below , it is easy to see that gold often rises when interest rates fall .
What is the correlation between gold and interest rates?
In technical terms, we would say that they are negatively correlated .
To summarise , with this post we seek to give our readers an idea of how important it is to analyse the risk profile of an asset not in isolation, but in the context of the entire portfolio .
Also, avoiding concentration in investments that are highly correlated helps reduce portfolio volatility and keeps sources of risk well diversified.
Concept
Correlation is an association between two numerical variables that assesses the trend (increase or decrease) in the data .
When one variable gives us information about another variable, we say that the two variables are related. On the other hand, when there is no correlation, the increase or decrease of one variable tells us nothing about the behavior of another variable.
The concept of correlation is used in finance to describe the degree to which two assets tend to move in the same direction. Correlation is usually summarized as a number ranging from -1 to 1.
-1 means perfect negative correlation
0 means no correlation
1 means perfect positive correlation
Positively correlated assets tend to move in the same direction most of the time. Negatively correlated assets, on the other hand, tend to move in opposite directions.
Very rarely is the correlation perfectly positive gambling data indonesia phone number or negative; most of the time the correlation value lies somewhere between -1 and 1.
In 1952, Harry Markovitz , then a 25-year-old graduate student, published " Portfolio Selection ," a 14-page article that changed the history of finance and for which he was awarded the Nobel Prize in 1990.
Markovitz described in a mathematical formula the benefit in terms of risk /return of placing in a portfolio securities that move independently to a certain extent.
Common sense has always recognized the benefits of diversification , of not putting all your eggs in one basket. This was intuitively true in finance as well, but no theory had described it mathematically until then. Markovitz was the first to describe the benefit of diversification in a quantitative way.
The key is to find assets that move independently of each other to some extent. The lower the correlation between assets, the greater the benefits of diversification.
The greater the degree to which assets move independently, the lower the risk that the portfolio will experience large fluctuations in value.
As you can see, this concept, which may seem simply statistical, is widely used in the world of finance. It allows us to compare the movement of certain assets with respect to others. In fact, the analysis of the variation of an asset with respect to others is crucial for the construction of stock portfolios .
Download guide Learn to invest easily
Correlation in investment
Intuitively, a portfolio consisting of a number of assets that move up or down at the same time will be riskier than a portfolio in which some assets move up when others move down.
In the first case, the investor would have a positively correlated portfolio, so the total value of the investment is likely to fluctuate much more than the value of the second portfolio.
In the second case, however, the investor would have a portfolio with negative correlation, the gains obtained from the securities that rise will offset, at least partially, the losses from the securities that fall. Therefore, you will be investing with a higher degree of diversification than in the first case.
Typically, investors prefer limited fluctuations.
Examples of what asset correlation means in the real world
Let's look, for example, at the commodity price index (in red) and the value of the Australian dollar (in blue).
Australia is a producer of commodities (copper and iron ore in particular), so the value of its currency is likely to be influenced by fluctuations in the prices of such commodities.
The correlation between commodities and the Australian dollar
From the chart above, it is evident that they tend to move in a synchronized manner. In technical terms, we would say that they are positively correlated .
Previously, in the post why invest in gold we explained how gold and interest rates often tend to move in opposite directions.
In the chart below , it is easy to see that gold often rises when interest rates fall .
What is the correlation between gold and interest rates?
In technical terms, we would say that they are negatively correlated .
To summarise , with this post we seek to give our readers an idea of how important it is to analyse the risk profile of an asset not in isolation, but in the context of the entire portfolio .
Also, avoiding concentration in investments that are highly correlated helps reduce portfolio volatility and keeps sources of risk well diversified.