Correlation
Candlefocus EditorIn finance, correlation is often used to quantify the correlation between a stock and a benchmark index, such as the S&P 500. By using a correlation coefficient, investors can assess the relationship between their investments and the performance of a broader market to determine the amount of risk they’re exposed to. Investors who wish to avoid heavy losses should insure that all the stocks they have bought have a strong negative correlation, indicating that they are not likely to all be affected by the same market conditions.
One of the most common ways of visualizing correlation is through a Scatterplot. This graph is used to identify the correlation between two variables. It plots each of the variables on a two-dimensional graph, with the x-axis representing one variable and the y-axis representing the second. The scatterplot can then be used to identify the strength of a correlation. A higher concentration of points near a straight line indicates a strong, linear correlation between the two variables; if the points have no visible pattern, or only a few points lie on a line, there is likely to be a weak correlation or none at all.
It is important to remember that correlation measures association but does not confirm that one variable causes the other, or even if the two variables’ association comes from a third factor. For example, it could be that high correlation exists between the increase of a certain stock and an increase in overall market performance, but the market’s increase may not be the reason for the stock’s increase.
In short, correlation describes how two variables are related to each other. It is a key concept in effective investment and can be used to ensure that an investor’s portfolio is diversified by making sure that all investments have a negative or low correlation. This is especially important in times of market volatility, and can help protect the investor’s capital. Correlation can be visualized using a scatterplot and is a useful tool for investors when assessing their investments.