Asset correlation is a measure that shows how prices of two securities move in relation to each other.
It's a powerful tool that is used in portfolio management. By including low or negatively correlated assets to a portfolio, the investor increases diversification and lowers risk.
How to use the asset correlation coefficient
According to modern portfolio theory, investors should choose assets for their portfolios that are less likely to lose value at the same time. In other words, the portfolio should be composed of weakly correlated assets. And assets with a strong correlation should be excluded from the portfolio whenever possible. Thus, the portfolio will be more resilient in different macroeconomic circumstances.
What Asset Correlation can tell you
The correlation coefficient can take values between -1.0 and +1.0.
- Positive correlation between assets indicates that they move in the same direction. That means when one asset price increases, the other asset price increases too and vice versa. The closer correlation to 1, the stronger relationship between price changes.
- Negative correlation indicates that asset prices move in opposite directions. When one increases, the other decreases.
- Close to zero correlation doesn't show any relation between price movements.
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