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What is correlation?
A correlation expresses how strong the relationship is between two variables. For example, there is a strong correlation between hot, sunny weather and the amount of ice cream sold. When the two variables move in the same direction, it is understood as a positive correlation. However, if they are moving in opposite directions, it is a negative correlation. When the correlation is zero, there is no relationship between the variables.
Where have you heard of correlation before?
Correlations are often evaluated by analysts and portfolio managers because understanding correlations is a risk management measure. Correlations are also often used in the field of psychology to observe behavioral patterns.
What You Need To Know About Correlation ...
The ability to see a correlation can help you weigh and mitigate risks.
Simply put, understanding correlations gives you insight into creating a portfolio that should the economy change negatively, the value of your investments would not be affected in the same way. For example, if a circumstance negatively affects how investors feel about certain stocks, the value of those stocks, regardless of whether the company is small or large, will go down - but perhaps not in the same proportion as investors believe that large companies are more likely to be in are able to endure a downturn. So the change in value would have a strong, but not perfect, correlation. This sentiment about stock values does not affect commodities because people definitely have to eat all the time and therefore the price of wheat, for example, is not affected by what happens to the stocks in question.
Some stocks can move in correlation. If the price of oil goes up, the value of oil companies will likely go up too, but the value of a transportation company will go down as that company has to bear additional costs for fuel. For example, some investors might use correlations to predict the direction of the market price.
You must also remember that correlation is not the same as causation. Just because two things react in the same or similar way to certain circumstances does not mean that one is causing the other to react. For example, in the 20th century there was a strong correlation between the number of radios bought and the number of people in psychiatry, but neither buying a radio causes you to be admitted to psychiatry, nor does buying a radio because you are in of psychiatry are. These are independent events.
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