The Correlation Coefficient

The correlation coefficient can range from -1 to +1. As Figure 20 illustrates, a correlation value near +1 indicates a high positive correlation between two investments. If one investment has positive returns during a period, it is highly likely that the other investment’s returns will also be positive.

Figure 20: Correlations between Investments

As Figure 21 illustrates, if two investments have a correlation of -1, the investments are negatively correlated, so if one investment has a positive return one month, it is likely that the other investment will have a negative return for that month.

Figure 21: Correlations between Investments - Take II

Finally, as Figure 22 illustrates, if an investment has a correlation approxamately equal to 0, the investments are not correlated to one another, and move independently. If one investment is up, the other could be either up or down. If one investment is down, the other could be either up or down.

Figure 22: Correlations between Investments - Take III

Investors who are required to select and monitor investment managers should develop a basic understanding of investment statistics. Quantitative tools can provide you with good insight that you can use in your qualitative interviews with managers and when monitoring your investments.