|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.