What Is Stock Correlation, and How Do You Find It?

Two stocks can look completely different on paper and still move almost in lockstep when the market shifts. Stock correlation helps investors measure that relationship, showing whether two investments tend to move together, in opposite directions or with little connection at all. Understanding correlation can make it easier to evaluate diversification, spot concentrations of risk and build a portfolio that is better balanced for your goals.

You can also consider working with a financial advisor, who can help you become more familiar with the basics of stock correlation, as well as make decisions regarding your investments.

What Is Stock Correlation?

Stock correlation measures how closely the prices or returns of two stocks move in relation to one another. Investors can use correlation to understand how different holdings may interact within a portfolio and whether they are likely to rise and fall at the same time.

Correlation is typically expressed on a scale from -1 to +1. A correlation of +1 means two stocks move perfectly in the same direction, while -1 means they move perfectly in opposite directions; a correlation near zero suggests there is little consistent relationship between their movements.

Stocks with a positive correlation tend to move in the same direction, which can happen when companies operate in the same industry or respond similarly to economic conditions. Stocks with a negative correlation tend to move in opposite directions, although consistently strong negative correlations between individual stocks are less common.

Understanding correlation can help investors build a more diversified portfolio. If most investments are highly correlated, they may decline together during certain market conditions, while combining assets with lower correlations could help reduce overall portfolio volatility.

Positive vs. Negative Stock Correlation

Stocks can be positively correlated when they move up or down in tandem. A correlation value of 1 means two stocks have a perfect positive correlation. A positive stock correlation means two stocks tend to move in the same direction. For example, if two companies operate in the same industry, their shares may both rise when conditions for that industry improve and fall when those conditions weaken. The closer the correlation coefficient is to +1, the more closely their movements have historically aligned.

If one stock moves up while the other goes down, they would have a perfect negative correlation, noted by a value of -1. A negative correlation means two investments tend to move in opposite directions. When one rises, the other is more likely to fall, although the relationship may not hold consistently over time. A correlation coefficient closer to -1 indicates a stronger historical tendency to move in opposite directions.

A correlation near zero suggests that the movements of two stocks have little consistent relationship. One stock may rise or fall without providing much indication of what the other will do. Holding investments with low correlations can potentially improve diversification because their returns are less likely to move together.

Investors often look at positive and negative correlations when deciding whether a portfolio is truly diversified. Owning several stocks may provide less diversification than expected if they are all highly positively correlated, while combining investments with lower or negative correlations may help reduce overall portfolio volatility. Correlation does not guarantee future performance, however, and relationships between investments can change as market conditions shift.

How to Calculate Stock Correlation

There are online calculators that can help you determine stock correlation. But it’s possible to run the numbers on your own. To find the correlation between two stocks, you’ll start by finding the average price for each one. Choose a time period, then add up each stock’s daily price for that time period and divide by the number of days in the period. That’s the average price.

Next, you’ll calculate a daily deviation for each stock. The deviation is the stock’s price on a given day, minus the average price. So if a stock’s average price is $25 per share and the daily price is $26.50 for a particular day, the deviation would be -$1.50. You’ll do this calculation for each day in the time period you’re measuring for each stock.

Putting It All Together

The next step is putting it all together. This is where it can get a bit complicated. First, find the square of each daily deviation for each stock. Then take this square daily deviation associated with the first stock for day one and multiply it by the square daily deviation for the second stock on day one, going down the list until you’ve done that for each day in the period.

This should give you three sets of numbers: all the squared deviations for stock one, all the squared deviations for stock two and a third group of all the numbers you got by multiplying each stock’s squared daily deviations by one another. Take all of the squared daily deviations for stock one and add them together, before taking the square root of the sum. This is the standard deviation. Do the same for stock two. Then multiply the standard deviations for the two stocks by one another, and put this number aside for the moment.

Finally, add all of the numbers in set three – the products of multiplying each day’s two squared deviations by each other – and add them together before taking the square root. Then divide this number by the product of the two stocks’ standard deviations.

The resulting number would range between -1 and 1, reflecting the two stocks’ correlation to one another.

Why Stock Correlation Matters for Investors

While you may be focused on how individual stocks in your portfolio react to the market independently of other stocks, understanding how they move alongside other stocks can give you a more cohesive view of your portfolio.

“Stock correlation is important because it can help show an investor that they may not be as diversified as they think,” Landsberg says. “You may have stocks in different sectors but if their returns depend on the same thing (e.g. the economy in a particular state) your portfolio is getting almost no protection from diversification.”

The Importance of Diversification

Diversification is a strategy for managing risk. It essentially means not putting all your eggs in one basket. Owning a mix of different stock types, mutual funds, bonds and other investments allows you to insulate your portfolio against inevitable bouts of volatility in the market. Portfolios that are “overweight” in one particular stock or sector are much more sensitive to market fluctuations. Understanding stock correlation can help you avoid that.

“Investors may be surprised to learn that only a few basic factors may be driving their portfolio,” Landsberg. “When you know how your stocks are correlated you can start to look at the factors driving the portfolio, which helps you be a better investor.”

Sometimes stock correlation can be obvious. For example, two stocks in the same industry or sector, such as banking or health care, are naturally more likely to move in the same direction and react to the market in the same way. Correlation may not be as easy to spot in your portfolio as within a mutual fund or exchange-traded fund.

For example, say you own stock shares in an energy company. Then you buy shares of an ETF that invests across multiple sectors, including energy. If the ETF holds shares of the same or a similar company, there could be overlap in your portfolio. This could potentially increase your risk factor if you’re overweight.

Using Correlation for Your Portfolio

Comparing individual stocks to market indexes is one way to use stock correlation. Index funds use this as a strategy. Index funds attempt to match the performance of an index such as the S&P 500 or the Nasdaq. You’d just want to be careful to avoid picking index funds that have a substantial number of the same stocks in common. This can hurt your diversification.

Holding stocks that have a negative correlation is another strategy to consider; this is sometimes referred to as “hedging.” Hedging balances out the positively correlated stocks in your portfolio to manage risk.

For example, real estate and stocks historically have a very low correlation to one another. Bond prices also tend to be negatively correlated with the stock market. This is why many investors use bonds to balance their portfolio and manage risk. The drawback to this sort of hedging, however, is that it can potentially affect your investment returns over the course of market cycles. When one stock or investment delivers solid returns, the negatively correlated one you bought as a hedge may drag down your returns.

Bottom Line

Stock correlation measures how closely two investments move in relation to each other, using a scale from -1 to +1. Understanding whether stocks are positively, negatively or weakly correlated can help investors evaluate diversification and manage portfolio risk more effectively. Because correlations can change over time, they are best used alongside other measures of risk, return and investment fit.

Tips for Finding a Financial Advisor

• If identifying and exploiting correlation patterns sounds complicated, consider getting professional help through a financial advisor with building your portfolio. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• An advisor can help you accomplish a specific goal. For instance, an advisor can help you determine whether you’ve got enough saved for retirement. If you’ve got children, you can work with an advisor develop a plan for college savings. Insofar as achieving these goals means growing your money, an advisor can put together a plan balancing growth and risk.