Measuring correlation is as important as portfolio diversification itself. We can’t diversify our portfolio without first measuring correlation between the assets and strategies in our portfolio.
In fact, not measuring correlation will potentially lead to the risk we are exposed to increasing. By having exposure in two correlated positions, we are effectively doubling our exposure to this risk.
So how do we measure correlation?
The method for measuring correlation will differ depending on what technique we are using to diversify our portfolio. Remember the four techniques we covered previously in this series. These were:
- Across asset classes
- Within the same asset class
- Across different timeframes
- Across trading strategies
Throughout this mini-series, we’re going to look at different methods of measuring correlation.
To kick things off; we are going to start with the Coefficient of correlation (r) or Pearson’s r, as it’s also known. Karl Pearson developed the idea. He also founded the world’s first university statistics department at the University College, London.
Pearson’s r measures the strength of a linear relationship between two variables. It does this by creating a line of best fit between variables and measures the distance of each variable to the line of best fit.
This results in a range of results between -1 and +1. -1 would be a negative correlation, 0 would be no correlation and you guessed it +1 would be a positive correlation.
What do we mean by positive and negative correlation?
An example of a positive correlation would be two separate trades in the same direction, on the same asset. When the asset price rises; both the trades will gain, due to the positive correlation between the two trades.
A negative correlation would be simply the opposite. Two separate trades in different directions on the same asset. When the asset price rises one trade will gain whilst the other loses and vice versa if the asset price falls.
Positive and negative correlation can both negatively affect our portfolio.
So why measure them individually?
We don’t have to. There is another way to measure correlation. The coefficient of determination (R²).
This takes Pearson’s r and squares it. Doing so removes the negative part of the range leaving a range of 0 to 1. 0 would equal uncorrelated and 1 would equal either positively or negatively correlated. As both positive and negative correlation will negatively impact the portfolio this way would seem to make sense.
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Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.