Correlation, by itself, cannot affect the stock market because it is simply the degree to which two things are observed to behave in the same way. However, the correlation between the activity of two stocks, or between a stock and the performance of a given index, sector or industry, can be a very important factor in developing a prudent investing strategy. Stock analysts use a measure called the correlation coefficient to make predictions about how a stock will behave based on past performance and the activity of another security with which the stock in question has been shown to correlate.
Key Takeaways
- The correlation between the activity of two stco*ks can be a very important factor in developing a prudent investing strategy.
- Stock analysts use the correlation coefficient to measure both the degree and direction of the correlation between any two stocks.
- The correlation coefficient can be anywhere between -1 and 1, though it is almost always in between. A coefficient of 0 indicates no relationship whatsoever.
- The correlation coefficient can be used to select stocks in different industries that tend to move in tandem, or to select stocks with a negative coefficient so that if one stock fails, the other is likely to get a boost.
What Is the Correlation Coefficient?
The correlation coefficient is used to measure both the degree and direction of the correlation between any two stocks. It can be anywhere between -1 and 1, though it is almost always in between. Any two securities that have a coefficient of 1 are said to be "perfectly" correlated. This means when one stock moves up five points, the other does exactly the same thing, at the same time. A correlation of -1 is a "perfect" negative correlation, meaning that when one stock goes up five points, the other loses five points. This kind of behavior is incredibly rare in the stock market, so perfect correlations are almost entirely theoretical.
How and Why Do Stocks Correlate?
Most stocks have a correlation somewhere in the middle of the range, with a coefficient of 0 indicating no relationship whatsoever between the two securities. The stock of a software company, for example, may have little to no correlation with the stock of a chain of auto parts stores because the businesses operate so differently. For example, the auto parts store company has a much higher dependence on the movement of physical goods than the software company.
But even such fundamental differences may not explain correlations or the lack of them. More often than not stocks show correlation of price movement because of how investors respond to them. For example, McDonalds (MCD) and Caterpillar (CAT) operate very different businesses, but their stocks are often highly correlated over time because both are components of major market indexes.
Using the Correlation Coefficient
When developing an investment strategy and selecting stocks for your portfolio, the correlation coefficient can be a very helpful tool. It can be used to select stocks in different industries that tend to move in tandem, or to hedge your bets by selecting stocks with a negative coefficient so that if one stock fails, the other is likely to get a boost.
When stocks have a correlation coefficient of 0, it does not mean they never behave in the same way; rather, it means that they are as likely to move differently as they are to move together, making them unpredictable. However, this also means there is less likelihood that many noncorrelated stocks will fail simultaneously.
Choosing a variety of stocks with different degrees and directions of correlation is one of the most common and effective diversification strategies. The result is a portfolio that displays a general upward trend, since, at any given time, at least one security should be doing well even if others are failing.
