What is Correlation?
Most investors will look to diversify their portfolio in order to reduce the effect of one company dropping in price. This is always a good idea, but will have very little difference if the fortunes of the companies you invest in are directly linked.
The financial term for this is correlation and assigns a value to how closely the two share prices follow each other. Correlation is not necessarily limited to the share prices of individual companies and it is possible to look at the correlation of different sectors or indices as well. While the use of correlation cannot completely guard against a major global crisis it should certainly help protect you from the effects of one share price dropping.
If two companies are so closely linked that their share prices move in an identical way and amount, then they have a correlation of 1. If their businesses are arranged so that one only gains when the other loses and vice versa, then their correlation would be -1. In reality this is very rare, and they will be somewhere between the two. It is possible for there to be no link at all between the fortunes of the two companies in which case we simply say there is no correlation.
The ideal is if you can find companies with negative correlation so that if one stock is losing value this will be cancelled out by the other gaining. These can sometimes be hard to identify, but a good place to start is with companies who depend heavily on a particular commodity and the suppliers of that commodity (for example an oil company and a transport company). These could have negative correlation because a rise in the price of the commodity is good for the supplier, but increases costs for the customer.
An alternative is to select companies with little or no correlation between them. While they will not necessarily cancel each other out there will be a much lower risk of one event having a dramatic event on the performance of your overall portfolio.
There is a mathematical formula for working out the exact correlation for those that are comfortable with statistical analysis, but there is also a shortcut to this. The easiest way is to plot the two share prices on a graph and see what the relationship between the two prices is. There are many websites which will even do this for you just by selecting the stocks and the time-frame you would like to consider. It is then just a case of comparing the peaks and troughs. Remember that correlation is only one factor in selecting which stocks you are going to invest in. It is still important to ensure that you are buying stock in a company that you feel will increase in value and not just because it has a negative correlation to another stock in your portfolio.
Correlation should be done over a timescale of several years if possible and certainly a minimum of one year. You need to consider that companies do evolve and change their focus so the correlation of the two companies may change over time.