WFU Law School
Law & Valuation
2.3.1 Portfolio Theory

2.3.2 Covariance Defined

As we have seen, for diversification to work there cannot be a perfect correlation between the returns on different assets. When one is down, the other must be up -- and vice versa.

What is correlation? It is a statistical measure of the relationship between series of numbers -- such as financial returns. Before considering an example of the effects and benefits of diversification, we should define some terms --

  • Correlation coefficient (or covariance) is a measure -- from +1 to -1 -- that measures the degree of the relationship, or correlation, between two series.
  • Positive correlation means that two series tend to move in the same direction -- when one goes up, the other goes up; when one goes down, the other goes down. This means the correlation coefficient is positive. If the series is perfectly positively correlated the coefficient is +1. For example, you and your shadow are perfectly positively correlated.
  • Negative correlation means that two series move in opposite directions -- when one goes up, the other goes down; and vice-versa. If two series are perfectly negatively correlated, the coefficient is -1. For example, when you clap your hands their motion is perfectly negatively correlated -- we hope.
  • Uncorrelated series lack an interaction between their returns -- when one goes up, the other might go up or might go down. The correlation coefficient is zero.
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2.3.1 Portfolio Theory

©2003 Professor Alan R. Palmiter

This page was last updated on: March 16, 2004