Correlation is a measure of the similarity in behaviour of two assets. This can be important when considering the diversification, in a portfolio of assets, as a portfolio consisting of assets which all behave in a similar way would result in larger swings in value, with all of the assets rising and falling in unison as market conditions changed.
Correlation is often measured from a value of +1 to -1; +1 indicates perfect correlation, meaning that the two assets will move perfectly in unison in the market. A value of 0, in between the two extremes, would indicate no correlation between the two assets. Finally, a value of -1 would mean that the two assets rise and fall in complete opposition to one another; when one rises, the other falls.
Example of a Correlation Matrix chart
The below example shows the correlation between three investment funds. Whilst fund 1 and 2 are both equity funds investing in shares of companies operating in Asia, the geographical coverage of fund 1 is specific to only Asia-Pacific regions, so the two funds are not entirely correlated but do react similarly in changing market conditions with fund 1 displaying a correlation rate of 0.94 with fund 2.
Fund 3 is a bond fund investing in European corporate bonds so its portfolio of holdings is constructed and managed very differently to fund 1 and 2. A bond fund does not behave in the same way as an equity fund, hence fund 3 has a much lower correlation to the other equity funds of 0.32 against fund 1 and 0.33 against fund 2.