Correlation
Correlation measures the degree to which the returns of two assets move together. Correlations are described on a scale that stretches from 21 to 11.
A perfect positive correlation (11) means that the two assets move in lock step with one another. So, if Tesco’s share price went up or down by a certain percentage and Sainsbury always went up or down by the same percentage then Tesco and Sainsbury would have perfect positive correlation. There is no reduction in volatility for a portfolio of perfectly correlated shares – it is merely averaged.
A correlation of 21 is perfect negative correlation. This time the movements are exact opposites, as in the case of our umbrella company and ice cream company. If they moved in opposite directions ...
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