Stock correlation describes the relationship that exists between two stocks and their respective price movements. It can also refer to the relationship between stocks and other asset classes, such as bonds or real estate. Even if you’ve turned over control of your investments to an investment advisor, it’s still a good idea to familiarize yourself with the basics of stock correlation.
In general, stock correlation refers to how stocks move in relation to one another. While we can speak generally about asset classes being positively or negatively correlated, we can also specifically quantify correlation.
“Stock correlation is on a scale from -1 to 1 and is calculated by looking at a pair of stocks over a time and figuring out their average movement,” says Michael W. Landsberg, principal and chief investment officer at Landsberg Bennett Private Wealth Management in Punta Gorda, Florida.
Correlation is meant to be measured over a period of months or years, rather than days, to get a sense of how two or more stocks move. An investor can get a sense of how two stocks are correlated by looking at how each one outperforms or underperforms their average return over time.Positive vs. Negative Correlation
Stocks can be positively correlated when they move up or down in tandem. A correlation value of 1 means two stocks have a perfect positive correlation.
If one stock moves up while the other goes down, they would have a perfect negative correlation, noted by a value of -1.
If each stock seems to move completely independently of the other, they could be considered uncorrelated and have a value of 0.Calculating Stock Correlation
There are online calculators that can help you determine stock correlation but it’s possible to run the numbers on your own. To find the correlation between two stocks, you’ll start by finding the average price for each one. Choose a time period, then add up each stock’s daily price for that time period and divide by the number of days in the period. That’s the average price.
Next, you’ll calculate a daily deviation for each stock. The deviation is the stock’s price on a given day, minus the average price. So if a stock’s average price is $25 per share and the daily price is $26.50 for a particular day, the deviation would be -$1.50. You’ll do this calculation for each day in the time period you’re measuring for each stock.
The next step is putting it all together. This is where it can get a bit complicated. First, find the square of each daily deviation for each stock. Then take this square daily deviation associated with the first stock for day one and multiply it by the square daily deviation for the second stock on day one, going down the list until you’ve done that for each day in the period.
This should give you three sets of numbers: all the squared deviations for stock one, all the squared deviations for stock two and a third group of all the numbers you got by multiplying each stock’s squared daily deviations by one another. Take all of the squared daily deviations for stock one and add them together, before taking the square root of the sum. This is the standard deviation. Do the same for stock two. Then multiply the standard deviations for the two stocks by one another, and put this number aside for the moment.
Finally, add all of the numbers in set three — the products of multiplying each day’s two squared deviations by each other — and add them together before taking the square root. Then divide this number by the product of the two stocks’ standard deviations.
The resulting number would range between -1 and 1, reflecting the two stocks’ correlation to one another.Why Correlation Matters for Investors
While you may be focused on how individual stocks in your portfolio react to the market independently of other stocks, understanding how they move alongside other stocks can give you a more cohesive view of your portfolio.
“Stock correlation is important because it can help show an investor that they may not be as diversified as they think,” Landsberg says. “You may have stocks in different sectors but if their returns depend on the same thing (e.g. the economy in a particular state) your portfolio is getting almost no protection from diversification.”
Diversification is a strategy for managing risk. It essentially means not putting all your eggs in one basket. Owning a mix of different stock types, mutual funds, bonds and other investments allows you to insulate your portfolio against inevitable bouts of volatility in the market. Portfolios that are “overweight” in one particular stock or sector are much more sensitive to market fluctuations. Understanding stock correlation can help you avoid that.
“Investors may be surprised to learn that only a few basic factors may be driving their portfolio,” Landsberg. “When you know how your stocks are correlated you can start to look at the factors driving the portfolio, which helps you be a better investor.”
Sometimes stock correlation can be obvious. For example, two stocks in the same industry or sector, such as banking or health care, are naturally more likely to move in the same direction and react to the market in the same way. Correlation may not be as easy to spot in your portfolio, however, if you own stocks within a mutual fund or an exchange-traded fund.
For example, say you own stock shares in an energy company, then buy shares of an ETF that invests across multiple sectors, including energy. If the ETF holds shares of the same or a similar company there could be overlap in your portfolio, potentially increasing your risk factor if you’re overweight.Using Correlation for Your Portfolio
Comparing individual stocks to market indexes is one way to use stock correlation. Index funds use this as a strategy. Index funds attempt to match the performance of an index such as the S&P 500 or the Nasdaq. You’d just want to be careful to avoid picking index funds that have a substantial number of the same stocks in common, since that can hurt your diversification efforts.
Holding stocks that have a negative correlation is another strategy to consider; this is sometimes referred to as “hedging.” Hedging balances out the positively correlated stocks in your portfolio to manage risk.
For example, real estate and stocks historically have a very low correlation to one another. Bond prices also tend to be negatively correlated with the stock market, which is why many investors use bonds to balance their portfolio and manage risk. The drawback to this sort of hedging, however, is that it can potentially affect your investment returns over the course of market cycles. When one stock or investment delivers solid returns, the negatively correlated one you bought as a hedge may drag down your returns.Tips for Finding a Financial Advisor
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