Michael James on Money: Understanding Correlation

Michael James on Money: Understanding Correlation

The idea of correlation can be confusing. Most of us have an idea of what seems correlated when we look at a stock chart, but this everyday idea of correlation can be very different from mathematical correlation.

Consider the following hypothetical chart of two stock indexes.

What would you guess is the correlation is between stocks indexes in this chart? Maybe 70% or 80%? They seem to move together quite a bit. When we focus on 1-year periods, the answer is a correlation of -0.2%! That's right – essentially no correlation.

However, if we look at rolling 5-year periods, the correlation is 88%. So, we get a completely different picture if we look at 1-year returns versus 5-year returns.

This discussion of 1-year and 5-year correlations can be confusing. After all, aren't we talking about 30 years here? Mathematical correlation in this context is about comparing two strings of numbers. We can make these two strings of numbers be 30 numbers long and consist of 1-year growth values, or we can make the strings 26 numbers long and consist of rolling 5-year growth values.

There is always a way to look at the numbers to get the result you want. As the saying goes, there are lies, damned lies, and statistics.