Correlation Coefficient

Correlation coefficient  is a statistical relationship between two or more variables that allows one to estimate the change in one variable while the other is changing.

The correlation coefficient is calculated on a specific historical interval. It is denoted by the letter r and takes values from -1 to +1. If the two assets move together, it means positive correlation and the coefficient will be closer to +1, and when they move in opposite directions, negative correlation occurs and the coefficient will be closer to -1. But when the correlation is close to zero, there is no dependance between them. This means that when one asset is rising or falling, the other asset may not show itself at all.

Investors when choosing securities for a portfolio often face a situation when, for example, price movements of several stocks turn out to be identical. So practically the correlation coefficient  is demonstrated through the dynamics of price movements of mentioned assets. The inclusion of a set of such correlated instruments in an investment portfolio can lead to both a significant increase in profitability and an increase in risks. The correlation coefficient helps assess the closeness of this relationship.

Correlation coefficient shows how assets are similar according to the description of their pattern. For example, if one asset becomes cheaper than another and this pattern is confirmed by historical data, assets are said to be inversely correlated. This applies to individual securities as well as to broad markets, asset classes and economic sectors.

In fact, correlation when dealing with securities allows you to assess the likelihood of synchronized price movements of two assets, such as a stock, or a stock and an index. This means that if there is strong correlation, if the price of one stock rises, the other stock will also rise in price. Or, as the index falls, the correlated companies' stocks will also fall in price.

Practically, it is possible to trade based on asset correlations. Usually, price movements of assets with forward or backward correlation do not occur instantly, but with some delay. For example, knowing that there is a positive correlation between a company's common shares and preferred shares and that the price movement of preferred shares occurs with a slight delay, you can set conditional orders in the trading terminal so that at the moment of an important news release, a trade in preferred shares will be executed while the common shares move in one direction or the other.

Correlation Coefficient  in investment portfolio construction

Diversification of assets into different asset classes is the basis of the most asset allocation strategies. In compliance with this approach, while some assets fall in value, others should rise. That is, the different positions in the portfolio should correlate as little as possible with each other. Ideally, the correlation coefficient should be negative. Then, as it is supposed, the risks will be balanced.

Classic asset classes for a long-term portfolio are stocks and bonds. One of the reasons for their continued proximity is investors' belief in their low correlation. Another popular asset class for passive investors is commodities (especially gold). 

Indeed, the correlation coefficient  of these asset classes may be low on long historical intervals. Also, armed with a computer and spreadsheets, you can find other examples of assets that have low or even negative correlations. It would seem that if we make up a portfolio of such assets, rebalance them once a year and we will be rich as a fairy tale.