Question

What does the correlation between the returns of two risky assets measure? Why should investors care about this measure?

Answer 1

A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all.

For example, large-cap mutual funds generally have a high positive correlation to the Standard and Poor's (S&P) 500 Index, very close to 1. Small-cap stocks have a positive correlation to that same index also, but it is not as high, generally around 0.8.

However, put option prices and underlying stock prices tend to have a negative correlation. As the stock price increases, the put option prices go down. This is a direct and high-magnitude negative correlation.

Importance of Correlation

Quite simply, it’s a way to diversify your portfolio. A highly correlated portfolio is a riskier portfolio—it means that when one of the stocks falls, it’s likely that all of them will fall. (On the other hand, if your stocks are going up, then a highly correlated portfolio might feel pretty good!) While you can never eliminate risk completely, you can build a portfolio with a mix of assets that are less correlated, uncorrelated, or negatively correlated to reduce your volatility and potential maximum drawdown.

Look at it this way: if you diversify, your return won’t be as high as your highest-returning asset, but it also won’t be as low as the lowest-returning.