Correlation is a fundamental concept in statistics and one of the most frequently cited statistical measures in finance. Positively correlated stocks tend to move up and down together, while negatively correlated stocks tend to move in opposite directions. Combining negatively correlated stocks in a portfolio can help investors reduce risk; such portfolios, however, also limit the investor's profit potential.
Two variables are correlated if their movements are related to each other. When given the movements in one variable, you can make an educated guess about the other, if there is a correlation. For example, the rainfall and umbrella sales in a city tend to be are correlated. If someone tells you what the weather was -- measured in inches per square-foot -- on a particular day, you can make an educated guess about umbrella sales, and that guess would be more accurate than just throwing dice to estimate umbrella sales. On the other hand, umbrella sales and the number of points scored by your favorite basketball team are not correlated. Knowing basketball scores won't help guess umbrella sales.
Positive Vs. Negative Correlation
Two variables are positively correlated if a rise in one is usually associated with a rise in the other. They are negatively correlated, if one tends to go down as the other rises. Umbrella sales and rainfall are usually positively correlated, because when one is above average, usually the other is too. Rainfall and the sale of sunglasses are negatively correlated. When one is above average, the other tends to be below average. Although the concept of correlation is straightforward, its precise measurement requires advanced math and mastering such concepts as correlation coefficients and R-Squared figures. Today, even the smartest experts rely on computers to calculate these figures.
When building a portfolio, investors seek negatively correlated stocks. Doing so reduces the risk of catastrophic losses in the portfolio and helps the investor sleep better at night. Assume the portfolio consists of two stocks and they are negatively correlated. This implies that when the price of one performs worse than usual, the other will likely do better than usual. The gain in one stock is therefore likely to offset the loss in the other. If the stocks are positively correlated, on the other hand, they tend to rise and fall together. While this is great if things go well and they both advance, if things go sour, they could both have a bad month or year, resulting in financial ruin.
Investing in negatively correlated stocks certainly is an appealing idea as it reduces the risk of a portfolio. However, it does have drawbacks as well. First, such a portfolio's profit potential is also limited. Since the rise in some stocks will likely mean a drop in others, such a portfolio exhibits mild gains as well as small losses. Furthermore, stocks that were negatively correlated in the past may start to behave independently of each other or begin to move up or down together. Numerous factors, such as merger talks between two companies or one firm expanding its product line to more closely resemble that of another, may result in such a situation.
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