Correlation

Two variables are positively correlated if they tend to rise and fall together, such as a country's income and its spending on travel. They are negatively correlated if one tends to rise when the other falls, such as interest rates and bond prices. If there is no consistent pattern, they are uncorrelated.

Correlation is usually measured with the correlation coefficient, a number between −1 and +1.

In investing, correlation is central to diversification. If two investments are highly correlated, holding both offers little protection, because they tend to fall at the same time. Combining investments with low or negative correlation can make a portfolio's overall value steadier.

For example, shares of two banks in the same country are likely to be highly correlated, while shares and government bonds have often had low or negative correlation, though this relationship can change over time.

An important warning applies: correlation does not prove causation. Two things can move together because of a third factor, or by coincidence. Ice cream sales and swimming accidents both rise in summer, but one does not cause the other. Correlations between financial assets also change, and often rise during market crises, just when diversification is most needed.