corelation meaning in finance and its uses – All you need to know

Corelation is an important parameter in finance to look at when you are doing asset allocation across stocks or across asset classes.
If you see the above image, wife and husband both are having angry faces.
When both are getting angry, it is very unlikely that the fight will end soon.
So, it is always wise for both husband and wife; if one of them is angry, the other one should be calm.
And if both of them have the same behaviour when getting angry, it is called a high co-relation.
Finally, in horoscopes, it is also very famous that both males and females should not become tigers or goats.
In addition, one can become a tiger, and the other can become a goat for the purpose of marriage.
So, we understood the correlation between horoscope and marriage.
Now, let’s understand this correlation between personal finance and investments.
What is corelation?…
Corelation in personal or in investments is a statistical measure that will tell us how two stocks or assets move in relation to each other.
In correlation is used advanced portfolio management, and it is calculated as a correlation coefficient.
And it always faffs in between values -1 to +1.
What correlation coefficient will tell you?…
It tells you how strong the relation is between two variables and it is numerically determined by the correlation coefficient.
And its values range from -1 to 1.
In addition, a perfect positive correlation means the correlation coefficient is equal to 1.
Moreover, it means that if a stock or asset moves up or down, the other stock or asset also moves in the same direction and in the same proportion.
That means if stock A goes up by 10%, the stock B also moves up 10%; both have perfect correlation.
Again, a perfect negative correlation means that if one stock or asset moves in one direction, the other stock moves completely in the opposite direction.
That means if stock A moves up 10%, then stock B moves down by 10% if both of them have perfect negative correlation.
For example, large-cap funds will have a high positive correlation to nifty 50 or close to 1.
How to calculate the correlation?…
Financial analysts, traders, and fund managers use this statistic to reduce the risk for the purpose of diversification
Let’s take a hypothetical example to calculate the correlation between data sets.
X:(33,57,55,40,23,19,41).
Y: (61,76,82,71,74,60,94).
There are 3 steps in finding the correlation…
First Step…
a) add all X values to find Sum (X),
b) and all Y values to find sum (Y).
c) Multiply sum (X) and sum (Y). and sum them all to find sum(X,Y).
2nd Step…
In the second step, take each X value and square is up and add these values to find Sum (X^2).
In addition, do the same thing to Y values to find Sum (Y^2).
Noting down all these 7 observations and the “N” value, you can calculate the correlation using the below formulae…
Finally, you can do this calculation in Microsoft Excel very easily.
Correlation and portfolio diversification…
Correlation is an important factor in constructing a diversified portfolio.
If you want to mitigate the risk, then its better to invest in stocks or assets that have a non-correlation or a low or very low correlation.
For example, if you are investing in airline stock already and a second stock if he wants to invest, social media stock has a low correlation with airline stock.
Moreover, if one industry goes into trouble, the other industry stock will not go into trouble, as the correlation for both of the stocks is very low.
as The airline industry will not impact the social media industry.
Again, this strategy can be used while investing in stocks or in different assets.
However, while structuring asset allocation, you will find some assets are highly correlated and some are very low correlated or negatively correlated.
Scatter Plots…
The easiest way to visualise how two variables are related is using a scatterplot.
In addition, each point on a scatterpoint represents one sample point.
And the X-axis of the scatterplot represents one variable and the Y-axis of the scatterplot represents another variable.
And a linear line can be drawn upwards if there is a positive correlation between two variables.
Similarly, a downward linear line can be drawn if there is a negative correlation between the two variables.
Moreover, the stronger the relation between the two variables, the closure will be scatter points to the linear line.
Finally, a scatterplot is useful to identify complex situations.
Sometimes two variables have positive correlation at some point and negative correlation at another point.
And a normal formula cannot identify this behaviour.
So, using a scatterplot, we can identify such nonlinear linear behaviour of two variables.
Caution…
One important difficulty in statistics is that the relationship between the two variables is caused by two variables.
“Most cricketers are tall, so if you play cricket, you will become tall.”.
We know that the above statement is not true.
In addition, individuals who are tall may find the advantage and may opt for cricket as a career because of their natural abilities, which best suit cricket.
However, because both height and activity are positively corelated, statisticians and data scientists must be aware that the strong relation between two variables may or may not be caused with one of the two variables.
Limitations of Correlation…
Like other statistical measures, correlation also may not be useful if the sample size of the data set is small.
In addition, a small sample size may give uncorrelated results, even if the two variables have strong correlation.
Moreover, the correlation is skewed if an outliner is present in the data set.
A correlation will tell you how one variable is related to another variable.
And it will not tell you how a single instance can impact the correlation coefficient.
Again, it will be difficult if there is no linear line in the scatterplot.
and it is much easier to understand the relation between two variables with a linear line.
What is correlation?…
Correlation is a statistical measure that tells you how much degree two variables move away in coordance with another.
If both the variables move in one direction, then both the variables have positive correlation.
And if the two variables move in different directions, then the two variables have a negative correlation.
What is an example of correction usage?…
Correlation is a widely used concept in modern finance.
For example, a trader or investor will try to find correlation using historical data on how a stock is moving with changing interest rates and commodity prices.
In addition, a portfolio manager also tries to invest in low-correlated assets with the help of a correlation coefficient to reduce the risk in the portfolio.
Is higher correlation better?…
Generally, investing in low-correlated stocks or assets is good to reduce the risk.
But the investors who are willing to take risk can consider investing in the same sector with a high positive correlation.
Read about the six asset allocation strategies…
Also read about tactical asset allocation…
And read about Lic Bima Bachat Plus…
Also read about Strategic Asset Allocation: All You Need to Know.
And read about portfolio rebalancing strategies—all you need to know…
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