A number between minus 1 and plus 1
The correlation coefficient is calculated from the two stocks' daily moves over a chosen period. It measures the strength and direction of the linear relationship between their moves. The closer it is to plus 1, the stronger the positive relationship: the two tended to rise and fall together in a steady way. The closer to minus 1, the stronger the negative relationship: one rises as the other falls. Around zero there is no clear linear relationship, which does not mean they are fully independent.
Holding both banks gives less diversification benefit, because their correlation of 0.8 is high; but they are not the same movement, and the benefit is not zero. The bank and the food company have a weaker linear link, so they can offer more diversification than the first pair, though correlation alone is not enough to judge a portfolio's risk.
Why do some stocks move together?
Usually because they respond to the same things: companies in one sector face the same decisions and prices, and almost all stocks respond to the general market mood, interest rates and the economy. Sometimes a correlation appears with no clear reason, a coincidence of the period measured.
Compare the stocks you hold
Open the correlation matrix and see how closely the stocks you hold move together.
Check yourself
1. Two stocks have a correlation of 0.9. What does it mean?
2. Which pair usually has the higher correlation?
Summary
- Correlation runs from minus 1 to plus 1 and describes the direction and strength of the link between two stocks' moves.
- Stocks driven by the same factors usually have a higher correlation.
- Correlation comes from the past, is neither a cause nor a guarantee, and often rises in sharp falls.