The Role of Correlation

The role of correlation

Ice cream sales tend to increase when the weather is warm, but fall when the weather gets colder. This is an example of correlation, which measures the strength of a relationship between two factors.

In financial markets, one example of correlation is that equity markets tend to increase in value when the economic outlook is favourable, but tend to decline when the economic news is less positive. Bonds react in an opposite manner, tending to decline in value during favourable economic conditions, but rising in value when the economy takes a downward turn. This is an example of inverse correlation.

Correlation is a very useful tool when you are establishing your asset allocation (how much you will be investing in stocks, bonds, property or alternative asset classes)

Correlation values range between +1 and -1. Assets that are perfectly correlated, or move together in the same direction, have a positive correlation of 1. Those that exhibit an inverse relationship (moving in opposite directions) have a correlation of -1. A correlation of zero implies that there is no relationship.

Combining low-correlating assets can help to diversify portfolio risk. Ideally, if an investor holds assets that are negatively correlated (when one goes up the other goes down) the overall volatility of the portfolio would be minimized. Using correlation as a reference point when building portfolios can be a useful tool in managing overall portfolio risk.

iShares wide range of ETFs offers you different ways of combining low-correlating assets in order to reduce the volatility of your investment portfolio’s performance