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Correlation Coefficient Formula

Correlation Coefficient

What is the Correlation Coefficient?

The correlation coefficient is a statistical measure that calculates the strength of the relationship between the relative movements of two variables. The values range between -1.0 and 1.0. A calculated number greater than 1.0 or less than -1.0 means that there was an error in the correlation measurement. A correlation of -1.0 shows a perfect negative correlation, while a correlation of 1.0 shows a perfect positive correlation. A correlation of 0.0 shows no relationship between the movement of the two variables.

Formula for calculating the correlation coefficient.

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Correlation Coefficient

Understanding the Correlation Coefficient

There are several types of correlation coefficients but the one that is most common is the Pearson correlation (r). This measures strength and direction of the linear relationship between two variables. It cannot capture nonlinear relationships between two variables and cannot differentiate between dependent and independent variables.

A value of exactly 1.0 means there is a perfect positive relationship between the two variables. For a positive increase in one variable, there is also a positive increase in the second variable. A value of -1.0 means there is a perfect negative relationship between the two variables. This shows that the variables move in opposite directions – for a positive increase in one variable, there is a decrease in the second variable. If the correlation is 0, there is no relationship between the two variables.

The strength of the relationship varies in degree based on the value of the correlation coefficient. For example, a value of 0.2 shows there is a positive relationship between the two variables, but it is weak and likely insignificant. Experts do not consider correlations significant until the value surpasses at least 0.8. However, a correlation coefficient with an absolute value of 0.9 or greater would represent a very strong relationship.

This statistic is useful in finance. For example, it can be helpful in determining how well a mutual fund performs relative to its benchmark index, or another fund or asset class. By adding a low or negatively correlated mutual fund to an existing portfolio, the investor gains diversification benefits.