How Does Correlation Coefficient Impact Investment Returns?
The correlation coefficient is a term used to describe the investment returns relationship strength between two investments. It helps an investor identify how similar their investment holdings returns are likely to be similar to each other. The correlation coefficient can be anywhere between +1 and -1.
How is Correlation Coefficient Measured?
The correlation coefficient of a portfolio is assigned a number that is between +1 and -1. If an investment portfolio has a coefficient of +1, it means the returns of the two securities are perfectly positively correlated. Said more plainly, if investment A goes up by 1% it’s likely investment B will also go up in value but not necessarily by the same 1% but it will likely go up. On the opposite end, a correlation of -1 means the investments are perfectly negatively correlated. If investment A goes down by 1% it’s likely investment B will also go down as well but not necessarily by the same 1%.
It’s also possible for two investment returns to have a coefficient of zero. If this occurs, it means that the investment returns are independent of each other. For example, if investment A had a positive return of 1% investment B could have a positive or negative return.
| Correlation Coefficient Chart Break-Down | |||
| Correlation Coefficient | Investment A | Investment B | Description |
| +1 | If it is up or down | Likely to go up or down like A | A correlation coefficient of +1 is known as perfectly positively correlated. They move in the same direction as each other but not necessarily by the same amount. |
| -1 | If it goes up or down | If A is up, it’s likely to be down. If A is down, likely to be up. | A correlation coefficient of -1 is known as perfectly negatively correlated. The investment tends to move in the opposite direction of each other’s return. This is what you want to aim for ideally. |
| 0 | If it goes up or down | Its return is independent of what A is doing. Could be up or down but it’s independent of A’s return. | |
Why is Correlation Coefficient Important?
To appreciate why the correlation coefficient is important, you first need to understand how risk is measured when it comes to investment. One common measure of risk is known as standard deviation, which simply measures the volatility of returns. For example, if you had two investments and investment A had a standard deviation of 2, while investment B had a standard deviation of 5 with both on average expected to return a 5% return.
Investment A’s journey to achieve those returns are likely to be less volatile compared to investment B. This means for investment A, you should expect the annual return in some years to drop to vary less from the expected annual return compared to investment B.
Since most people’s collections of investments are made up stock and bonds, understanding the relationship between these two asset class and their expected returns is important when constructing your portfolio. As such, the relationship returns between the individual stocks or bonds within the portfolio will also contribute to the level of volatility (risk) experienced by the portfolio’s standard deviation.
In short, if you hold a group of investments within your portfolio that all perform similarly, your portfolio is likely to experience greater volatility if market conditions are likely to result in those investments producing a poor return.
However, if you have a group of investments that are perfectly negatively correlated to each other, you are able to reduce your portfolio’s overall volatility. For example, we know typically that bonds and stocks tend to have a negative relationship with each other. Therefore, if say you have a 50/50 mix of bonds and equities in your investment, the theory says that if stocks are doing well, it’s likely your bonds are not doing well. If bonds are doing well then it’s likely stock isn’t doing well. When you have both as a 50/50 in your investment, you can achieve what’s known as a cancel-out effect.
If the stock market isn’t doing well, by holding bonds you can reduce (offset) the volatility your portfolio will experience by having bonds that are likely to be doing well when the stock market is down as investors seek bonds for safety. That’s why it’s important you hold a diverse group of investments that are perfectly negatively correlated to each other to cancel out their respective volatility within your portfolio.
How do you Calculate Correlation Coefficient?
The calculation of the correlation coefficient involves a statistical equation to determine the covariance amount of two variables and can be a complex calculation. While you can manually calculate your correlation coefficient, this may become time-consuming. Instead, you should simply know of this term and ask the individual you are dealing with if they are able to provide you with an idea of your portfolio correlation. Most investment funds will outline what the correlation coefficient is for the fund you’ve decided to invest in.
How to Use Correlaation Coefficient for your Investment
The basic takeaway from the correlation coefficient is to be aware that you want to have an investment portfolio that’s closer to -1 or moving towards being negatively correlated to each other. When you have such a portfolio, you can reduce the risk you may experience as you don’t hold investments that perform the same. As such, once some portion of your investment might be down, you may have other portions of your investment doing well, which will help reduce the overall risk your experienced compared to having investments that are all positively correlated to one another.
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