DRW Financial
  • Home
  • Contact
  • Blog
  • ADV, Privacy, Disclaimers
  • Home
  • Contact
  • Blog
  • ADV, Privacy, Disclaimers
Search by typing & pressing enter

YOUR CART

9/17/2015

brief explanation: correlation

In discussions of policy and process, there is a phrase that gets a lot of play: "Correlation does not imply causation".  One interpretation of that expression is that just because two (or more) things appear to happen or appear together regularly doesn't mean there is an explicit and clear connection between them.

In finance, correlation is about math

One aspect of the scientific and philosophic approach to portfolio design is recognition that there may be some connections between discrete pieces of a portfolio, and it is important to seek those out and consider their impacts.
Picture
Keeping this simple: a correlation measure can range from -1 to +1 (Negative 1 to positive 1).  A correlation of +1 means that two things move together in perfect lockstep; a negative one means a perfect inverse relationship.  Zero, right in the middle, suggests there is no implied or explicit relationship between the two things.  In the chart above, the price of Apple's stock appears to be positively correlated with the S&P 500 for much of the last three years.

don't assume too much

In my practice, I try to look at statistical data like this with some skepticism to see if I can understand the underlying connection.  If someone finds strong correlation between the height of a population and their preference for lattes over cappuccinos, I may do a little more digging to data manipulation.  In the case shown above, however, it makes some sense that Apple and the S&P 500 tend to move together sometimes.  For one thing, Apple is a member of that index, so Apple's movement does, itself, contribute to the overall performance of the index.  Second, Apple is a disproportionately large contributor to the index.
Picture
Lastly, Apple is a huge company with a large presence in the US financial markets, and large companies tend, in general, to move in sync with other large companies.

zero correlation raises diversity

If the goals for a given portfolio include a need for diversity (and risk sensitive portfolios should), the designer should run some testing on correlations among constituents.

Comments are closed.

    Author

    David R Wattenbarger, president of DRW Financial

    Archives

    June 2022
    May 2022
    April 2022
    January 2021
    November 2020
    May 2020
    March 2020
    February 2020
    November 2019
    August 2019
    September 2018
    February 2018
    December 2017
    November 2017
    March 2017
    February 2017
    October 2016
    September 2016
    January 2016
    November 2015
    September 2015
    June 2015
    March 2015
    December 2014
    October 2014
    September 2014
    August 2014
    June 2014
    May 2014
    April 2014
    January 2014
    December 2013
    July 2013
    June 2013
    May 2013
    April 2013
    March 2013

    Categories

    All Survey Video

    RSS Feed

Powered by Create your own unique website with customizable templates.