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miércoles, 10 de febrero de 2016

Correlation among stocks: Do you consider it in your trading?

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One of the fundamental concepts in which are based the stock market managers when they manage the portfolios under their responsibility is the correlation between the different stocks making up those portfolios. However, this concept can also be very useful for the retail investor.
Correlation is a statistical concept that indicates the relationship between two or more variables

So, if we have two variables, A and B, there will be a positive correlation between the two if the increase of value of A increases the value of B and vice versa. Conversely, there is a negative correlation when the behavior is reversed.  That is, when A increases then B decreases and vice versa.

When investing in the stock market, the correlation between the various stocks plays an important role, because the higher the degree of correlation between securities, more similar will be the behavior of their prices.

Creating portfolios with low levels of correlation between the different securities that compose them is one of the strategies that exist in the world of asset management to implement a good diversification.

The less correlation between assets that form a portfolio, the greater the difference that could be in the behavior of each one of them as the market falls.

Thus, if a portfolio is very diversified because the assets that compose it are uncorrelated, you can have a better performance than other portfolios with the highest degree of correlation between assets. In a portfolio with a low degree of correlation, the fall in the price of an asset can be seen compensated by the good performance of the other.

How can retail investors work with the concept of correlation? Leaving aside statistical calculations, the retail investor can determine the degree of correlation between two assets intuitively considering the following:
  • Under normal conditions, the shares of two companies in the same industry tend to have similar behavior, ie are highly correlated.
  • We can guess the correlation between two stocks by analyzing their medium and long term charts: the more similar the evolution of prices in the medium/long term, the higher the degree of correlation.

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