Glossary
Correlation
A statistic from -1 to +1 describing how closely two series move together; low correlation is what makes diversification work.
Correlation measures how consistently two things move together. The correlation coefficient runs from +1, where two series always rise and fall in step, through 0, where their moves are unrelated, to −1, where one reliably rises when the other falls. In investing it is usually computed on returns, and it is the quiet engine behind Diversification.
How it is calculated
The standard measure, Pearson's correlation, compares how two return series vary together with how much each varies on its own.
Reading it correctly
- Strength, not size. A correlation of 0.9 says two stocks move in the same direction most of the time, not that they move by the same amount. That second question is what Beta answers.
- It changes. Correlations measured over calm years often jump toward +1 in a crash, just when diversification is wanted most. Stocks and Treasuries, which had mostly offset each other for two decades, fell together in 2022.
- Window matters. A 60-day and a five-year correlation between the same pair can differ sharply, so always note the period.
- Not causation. Two series can be correlated by coincidence or because both respond to a third factor such as interest rates.