If you’re in charge of handling your own investment portfolio, now might be the perfect moment to go back into the lessons of high school math. Explore the idea of how stock correlation can enhance your skill in effectively managing your investments.
The Context
Portfolio management is an important concept that aligns with all sorts of DIY investment and educational philosophies. If you prefer taking charge of your finances, you must know that successful portfolio management involves mastering several financial concepts one of the most important being awareness of stock correlation.
While it might seem fancy and complex, we’re here to simplify it for you, making it easy to understand and apply.
In simple words, stock correlation measures how different assets or stocks in your portfolio interact with each other. If you discover that your stocks are highly correlated, it might indicate that your diversification efforts need improvement, potentially affecting your long-term financial goals. In this guide, we’ll explore why correlation matters in managing your investment portfolio, provide a step-by-step guide on calculating it, and discuss practical ways to apply this knowledge to your investment strategy.
What is Stock Correlation?
Types of Correlation
Essentially, the stock market can be boiled down to three variables: up, down, or sideways. Similarly, when we break down the concept of correlation among its components, individual stocks can display three distinct types of correlation—Positive, Negative, and uncorrelated!
Positive Correlation
Think of a positive correlation as a situation where two stocks typically move together. Imagine a perfect positive correlation, represented by a correlation coefficient of 1 (one), like banking and real estate. Stocks in both sectors often rise or fall together because they’re influenced by factors like interest rates and the overall state of the economy. So, when interest rates go up or the economy improves, both the banking and real estate sectors tend to benefit simultaneously.
Negative Correlation
When the correlation is represented as -1 (minus one), it means that two stocks typically move in opposite directions. Think of this as a negative correlation, often seen between stocks from different sectors, like utilities versus energy stocks. Utilities, such as electric or gas companies, and energy stocks, like oil and gas exploration companies, often show this negative correlation. When energy prices go up, it can result in increased expenses for utilities, which, in turn, can hurt the prices of utility stocks.
Uncorrelated
When the correlation is represented as 0 (zero), it signifies that two stocks move independently of each other, indicating an uncorrelated relationship with a correlation coefficient of 0. For example, consider technology versus agriculture stocks. A technology company’s stock and a traditional agriculture company’s stock may exhibit this lack of correlation. They operate in different sectors with distinct influencing factors, so changes in one are unlikely to significantly affect the other.
Understanding these correlations is valuable for building safer portfolios as it enables you to construct a well-balanced portfolio that spreads risks effectively, providing stability in various market conditions.
Calculating Correlation
Determining stock correlation requires a series of steps, and here’s a breakdown of those steps. We’ll take it slowly to make it understandable.
Step 1. Collect Data
Collect historical price data for the stocks you want to analyze. Ensure you have data for the same time periods to ensure accuracy. The timeframe of your data or stock prices depends on your investment horizon. Short-term traders often focus on daily or weekly price data, while long-term investors are generally more interested in assessing variations using monthly or yearly prices.
This can easily be obtained from the NSE website. Secure your date, week, month, or year-wise data on an Excel sheet to proceed ahead.
Step 2: Calculate Returns
In Excel, create a column for each stock’s returns. Use the formula: =(Current Price – Previous Price) / Previous Price.
For example, if your prices are in columns B (current) and A (previous) starting from row 2, in cell C2, enter =(B2-A2)/A2 and drag it down for all data points.
Step 3: Calculate the Mean and Standard Deviation
You will have to do this for each stock.
To calculate the mean (Average), use the following formula-
=AVERAGE (YourRange) where YourRange is the range of returns for a specific stock.
To calculate the standard deviation, use the following formula-
=STDEV (YourRange) for the same range.
Step 4: Calculate Covariance
In Excel, you can use the COVARIANCE.P function. For example
=COVARIANCE.P (Range1, Range2), where Range1 and Range2 are the return ranges for the two stocks.
Step 5: Calculate Correlation Coefficient
This is also referred to as ‘r’ and to derive this, use the CORREL function in Excel.
=CORREL (Range1, Range2), where Range1 and Range2 are the return ranges for the two stocks.
The resulting ‘r’ value will fall between -1 and 1.
- A value of 1 indicates a perfect positive correlation,
- -1 indicates a perfect negative correlation, and
- 0 indicates no correlation.
The mathematical formula to derive this is:
If you’re looking to effortlessly perform these calculations, an Excel workbook is a handy tool. However, if you’re keen on brushing up your algebra skills, feel free to explore the correlation coefficients lesson on cuemath.com by clicking here.
It’s a recommended resource for rediscovering the joy of math!
Alternatively, don’t hesitate to contact us if you’re interested in acquiring knowledge about this concept through our premium stock market training modules.
Correlation and Investors
Understanding stock correlation is crucial because it provides insights into portfolio diversification. Even if you own stocks from different sectors, if they are highly correlated due to shared factors, your portfolio may not be as diversified as you think. Diversification is essential for managing risk and reducing your sensitivity to market ups and downs.
By comprehending how your stocks are correlated, you can pinpoint what drives your portfolio’s performance and make smarter investment decisions.
Using Correlation for Your Portfolio
1. Comparing to Market Indexes
You can use correlation to compare individual stocks to market indexes. Be cautious when selecting index funds to avoid significant overlap with your existing holdings, which could undermine diversification.
2. Hedging with Negative Correlation
Holding stocks with negative correlation is a risk management strategy known as “hedging.” For instance, real estate and stocks historically have low correlation, making real estate a potential hedge against stock market volatility. However, be aware that hedging can impact returns over market cycles.
Conclusion
If you like handling your own stock portfolio, knowing about correlation is really useful. It assists you in creating a well-diversified portfolio like the pros and hedging your risks more efficiently.
Understanding why correlation matters, learning how to calculate it, and using these insights in your investments, much like experienced professionals, can help you feel more certain about your investment choices.
🔔 Invest wisely!
