When selecting various assets for your Portfolio, you may be tempted to avoid those with a high Correlation.
>Huh?
Many think of "Correlation" as being an indication of whether the prices of two stocks move up and down together.
The most common flavour of "Correlation" is the Pearson productmoment Correlation Coefficient ,
applied to two sets of returns ... probably monthly returns, over the past few years.
The Pearson Correlation is a number between 1 and +1 and when it's close to +1 one (often) interprets that to mean that the two stock prices tend to move up and down together.
In such a case, maybe you wouldn't want both stocks in your Portfolio ... if they move together.
However, the Pearson Correlation actually measures whether the two sets of returns tend to be above or below their average together ... and that's a horse of a diff'runt hue.
It's quite possible to have one stock go up as the other goes down and still have a Correlation of +1.
It's also possible to have both stocks go up yet have a Correlation of 1.
NOTE: Sometimes I use a percentage between 100% and +100% to denote correlations.
Most people just use a number between 1 to +1.
However, there are other measures of "correlation" such as Spearman Correlation.
Investors often look at the square of the Pearson Correlation (calling it Rsquared).
The bad thing about Rsquared is that is doesn't distinguish between positive and negative correlation.
The good thing about Rsquared is that is gives some measure of how far the returns are from being linearly related.
