What is relevance

Correlation is a statement of the closeness of the relationship between two variables. For example, hot weather may be strongly correlated with ice cream sales. If two variables change in the same direction, they are positively correlated. Conversely, if the direction of change is opposite, it is negatively correlated. If it is zero, the two are not related.

Where have you heard about correlation?

Analysts and portfolio managers often focus on correlations because they must be understood when managing risk. Correlations are also commonly used in psychology to understand patterns of behavior.

The information you need to know about the relevance...

Being able to spot correlations helps you measure and mitigate risk.

In short, Understanding Correlation can provide you with insights into building a portfolio and ensure that when the economy changes, the value of all investments is not affected in the same way at the same time. For example, if an investor's stock holdings are adversely affected, the value of the shares of large and small companies may fall, but to different degrees, because, as investors find, large companies are better able to cope with the recession. Thus, changes in value may be strongly correlated, but not completely correlated. This view of stock value does not necessarily affect commodities because people can't live without their diet, wheat prices may not be as affected as stock values.

Movements in certain stocks may be correlated. If the value of crude oil rises, the share price of the crude oil company may likewise rise, but the share price of the transportation company will fall because the rise in fuel costs will offset some of the profits. Some investors use correlations to predict future market price directions.

You also need to keep in mind that relevance does not represent inevitability. The fact that two things react in the same or similar way under certain circumstances does not mean that one thing causes the other. For example, in the 20th century, there was a strong correlation between the number of radios purchased and the number of people in mental hospitals, but buying a radio did not send you to a mental hospital, nor did going to a mental hospital get you a radio. These are two separate events.