What is correlation?

In investing, correlation refers to the statistical relationship between the movements of two or more assets or financial instruments.

Correlation measures the degree to which these assets move in relation to each other. This degree offers investors insights into their codependency.

Correlation is measured by a correlation coefficient, which typically ranges from -1 to +1 (a negative to a positive correlation).  Assets with a perfect negative correlation (-1) move in opposite directions. Assets with a perfect positive correlation move in unison (+1). A correlation of 0 suggests that there is no linear relationship between the assets; they move independently of each other.

Understanding the correlation between your investments is key for risk management. By diversifying your investment portfolio with assets that have low or negative correlations, you can reduce the overall risk of your portfolio. That’s because negative correlations can provide a hedge, helping to offset any losses. On the other hand, if your portfolio is full of assets that have a high positive correlation, they’re likely to move (and decline) in tandem.

It’s worth noting, however, that correlation does not mean causation. Other factors may influence the behaviors of assets beyond the statistical relationship between them.

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