CORRELATION
Back to GlossaryDefinition
A statistic that measures the degree to which two securities move in relation to each other.
Summary
Correlation is a statistical measure that shows how closely two securities (like stocks, bonds, or other investments) move together. It's expressed as a number between -1 and +1. A correlation of +1 means the securities move perfectly in the same direction, -1 means they move in perfectly opposite directions, and 0 means there's no relationship between their movements. Understanding correlation helps investors diversify their portfolios by combining securities that don't move in lockstep, potentially reducing overall risk.
Usage Context
Critical for understanding portfolio diversification, risk management, asset allocation strategies, and modern portfolio theory. Essential when discussing how to build balanced investment portfolios and measure systematic vs. unsystematic risk.
Common Confusions
- Thinking correlation implies causation (one security causes the other to move)
- Confusing correlation with covariance (correlation is standardized, covariance is not)
- Believing that zero correlation means no relationship whatsoever
- Assuming correlation remains constant over time
- Mixing up positive correlation with good performance
