Correlation Coefficient
Correlation coefficient (r) measures the degree to which two investments move together, ranging from +1 (perfect positive) through 0 (no relationship) to -1 (perfect negative), used in portfolio diversification.
Exam Tip
+1 = perfect positive, -1 = perfect negative, 0 = no correlation. Lower correlation = better diversification. Correlation is between -1 and +1.
What is Correlation Coefficient?
Correlation measures how two investments move relative to each other, ranging from -1 to +1.
Correlation Values
| Value | Meaning |
|---|---|
| +1 | Perfect positive (move together) |
| 0 | No relationship |
| -1 | Perfect negative (move opposite) |
Diversification Benefits
| Correlation | Diversification Benefit |
|---|---|
| +1 | None |
| <+1 to 0 | Some benefit |
| <0 to -1 | Maximum benefit |
Key Point
Maximum diversification with NEGATIVE correlation. Assets that move opposite reduce portfolio volatility.
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Related Terms
Modern Portfolio Theory (MPT)
MPT is Markowitz's 1952 framework for constructing portfolios to maximize expected return for a given risk level through diversification.
Diversification
Diversification is an investment strategy that spreads investments across various assets, sectors, or geographic regions to reduce risk without necessarily sacrificing returns.
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