Correlation coefficients are indicators of the strength of the relationship between two different variables. A correlation coefficient that is greater than zero indicates a positive relationship between two variables. A value that is less than zero signifies a negative relationship between two variables. Finally, a value of zero indicates no relationship between the two variables that are being compared.

Key Takeaways

  • Correlation coefficients are used to measure the strength of the relationship between two variables.
  • Correlation coefficient greater than zero indicates a positive relationship while a value less than zero signifies a negative relationship and a value of zero indicates no relationship between the two variables being compared.
  • Negative correlation, or inverse correlation, is a key concept in the creation of diversified portfolios that can better withstand portfolio volatility.

Understanding Correlation

The correlation coefficient () is a measure that determines the degree to which the movement of two different variables is associated.聽The most common correlation coefficient, generated by the Pearson product-moment correlation, may be used to measure the linear relationship between two variables.聽However, in a non-linear relationship, this correlation coefficient may not always be a suitable measure of dependence.

The possible 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, and a聽correlation of -1.0 indicates a perfect negative correlation, and聽a correlation of 1.0 indicates a perfect聽positive correlation. Anytime聽the correlation coefficient is greater than zero, it's聽a positive relationship. Conversely, anytime聽the value is less than zero, it's聽a negative relationship. A value of zero indicates that there is no relationship between the two variables.

Correlation among variables does not (necessarily) imply causation.

In the financial markets, the correlation coefficient is used to measure聽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 蟻 is close to zero,聽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 that 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.

Graphs showing positive, negative, and no correlation
Investopedia / Hugo Lin


To calculate correlation, one must first determine the聽covariance聽of the two variables in question. Next, one must calculate each variable's聽standard deviation. The correlation coefficient is determined by dividing the covariance by the product of the two variables' standard deviations.

Standard deviation is a measure of the聽dispersion聽of data from its average. Covariance is a measure of how two variables change together. However, its magnitude is unbounded, so it is difficult to interpret. By dividing covariance by the product of the two standard deviations, one can calculate the聽normalized version of the statistic. This is the correlation coefficient.


Positive Correlation

A positive correlation鈥搘hen the correlation coefficient is greater than 0鈥搒ignifies that both variables move in the same direction. When 蟻 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 蟻 is to +1, the stronger the linear relationship. For example, suppose the value of oil prices is directly related to the prices of airplane tickets, with a correlation coefficient of +0.95. 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 also decrease. And if the price of oil increases, so do the prices of airplane tickets.

In the chart below, we compare聽one of the largest U.S. banks, JPMorgan Chase & Co. (JPM), with聽the Financial Select SPDR ETF (XLF).锘 As you can imagine, JPMorgan Chase & Co. should聽have a positive correlation to the banking industry as a whole. We can see the correlation coefficient (bottom of the chart)聽is currently at 0.97 which is signaling a very strong positive correlation. A reading聽above 0.50 typically signals聽a positive correlation.

Correlation Coefficient - JPM, XLF
Source: TradingView.

Understanding the correlation between two stocks (or a single stock) and its industry聽can help investors gauge how the聽stock is trading聽relative to its peers. All types of securities, including bonds, sectors, and聽exchange-traded funds (ETFs)聽can be compared with the correlation coefficient.聽

Negative Correlation

A negative (inverse) correlation聽occurs聽when the correlation coefficient聽is less than 0. This is an indication that both variables move in the opposite direction. In short, any reading between 0 and -1 means聽that the two securities move in opposite directions. When is -1, the relationship is said to be perfectly negatively 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 they are almost never exactly correlated all the time).聽

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聽can help investors diversify聽their portfolio by including a mix of investments聽that have a negative, or low, correlation to the stock market. In short, when reducing volatility risk in a portfolio,聽sometimes opposites do attract.聽聽

For example, assume you have a $100,000 balanced portfolio that is invested 60% in stocks and 40% in bonds. In a year of strong economic performance, the stock component of your portfolio might generate a return of 12%, while the bond component may return -2% because interest rates are rising (which means that bond prices are falling). Thus, the overall return on your portfolio would be 6.4% ((12% x 0.6) + (-2% x 0.4). The following year, as the economy slows markedly and interest rates are lowered, your stock portfolio might generate -5% while your bond portfolio may return 8%, giving you an overall portfolio return of 0.2%.

What if, instead of a balanced portfolio, your portfolio was 100% equities? nba腾讯体育直播ing the same return assumptions, your all-equity portfolio would have a return of 12% in the first year and -5% in the second year. These figures are clearly more volatile than the balanced portfolio's returns of 6.4% and 0.2%.

The Bottom Line

The correlation coefficient can be helpful in聽determining the relationship between an investment and the overall market or other securities. This statistical measurement is useful in many ways, particularly in the finance industry. For example, it can be helpful in determining how well a mutual fund is behaving compared to its聽benchmark聽index, or it can be used to determine how a mutual fund behaves in relation to another fund or聽asset class. By adding a low, or negatively correlated, mutual fund to an existing portfolio,聽diversification聽benefits are gained.