Correlation
Correlation
A statistical measure of how two securities move in relation to each other, expressed as a coefficient ranging from -1.0 to +1.0. Perfect positive correlation (+1.0) means securities move together identically, perfect negative correlation (-1.0) means they move in exact opposite directions, and zero correlation (0) means no relationship exists. Low or negative correlation between holdings is essential for effective portfolio diversification.
Stocks and bonds typically have low or negative correlation, making them effective diversification partners. When equity markets decline, investors often move to Treasury bonds for safety, causing bonds to rise while stocks fall (inverse relationship). In contrast, technology stocks tend to have high positive correlation with each other, providing limited diversification benefits since they tend to move together.
Students often confuse correlation with causation (correlation does not imply one causes the other) or mistakenly believe high correlation improves diversification (actually, LOW or NEGATIVE correlation improves diversification by reducing portfolio volatility).
How This Is Tested
- Understanding that low or negative correlation between securities improves diversification effectiveness
- Interpreting correlation coefficients: +1.0 (perfect positive), -1.0 (perfect negative), 0 (no correlation)
- Recognizing that securities in the same sector typically have high positive correlation
- Identifying appropriate asset pairs for diversification based on correlation characteristics
- Understanding that correlation measures linear relationship but does not imply causation
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Perfect positive correlation | +1.0 | Securities move together identically in the same direction |
| Perfect negative correlation | -1.0 | Securities move in exact opposite directions |
| No correlation | 0 | No linear relationship between security movements |
| Correlation coefficient range | -1.0 to +1.0 | All correlation values must fall within this range |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Maria, age 52, is reviewing her $600,000 retirement portfolio with her investment adviser. Currently, the portfolio holds 15 different large-cap technology stocks. Maria wants to improve diversification to reduce volatility as she approaches retirement in 10 years. The adviser calculates that the average correlation between these technology holdings is approximately 0.85. Which recommendation would most effectively improve portfolio diversification?
B is correct. The current portfolio suffers from high correlation (0.85), meaning the technology stocks move together and provide minimal diversification benefits. Adding securities with LOW correlation (0.1 to 0.3) to technology stocks such as Treasury bonds (often negatively correlated with stocks), utilities (defensive sector), and healthcare (different economic drivers) would significantly reduce portfolio volatility through effective diversification.
A is incorrect because adding more technology stocks with similar high correlation (0.85) does not improve diversification. they will continue to move together during sector-specific downturns. C is incorrect because increasing concentration increases risk rather than reducing it, and high correlation is the problem, not the solution. D is incorrect because 0.85 correlation is HIGH, not low; effective diversification requires LOW or NEGATIVE correlation between holdings.
The Series 65 exam tests your ability to recognize when correlation analysis reveals inadequate diversification and recommend appropriate corrective actions. Understanding that high correlation between holdings (like sector concentration) defeats the purpose of diversification is critical for constructing portfolios that actually reduce risk through proper asset selection.
What is the range of possible values for a correlation coefficient between two securities?
C is correct. Correlation coefficients range from -1.0 (perfect negative correlation) to +1.0 (perfect positive correlation). A value of 0 indicates no linear relationship. This standardized scale allows consistent comparison of relationships between any two securities.
A (0 to +1.0) is incorrect because it excludes negative correlation values, which are possible and desirable for diversification. B (-1.0 to 0) is incorrect because it excludes positive correlation values, which are common among securities in the same sector or asset class. D (-100 to +100) is incorrect; correlation coefficients are standardized ratios, not percentages, and always fall between -1.0 and +1.0.
The Series 65 exam frequently tests knowledge of correlation coefficient ranges and interpretation. Understanding that correlation is bounded between -1.0 and +1.0 is fundamental to analyzing portfolio diversification effectiveness and interpreting statistical relationships between securities.
Master Investment Vehicles Concepts
CertFuel's spaced repetition system helps you retain key terms like Correlation and 500+ other exam concepts. Start practicing for free.
Access Free BetaAn investment adviser is analyzing correlation coefficients for potential diversification partners with a client's existing stock portfolio. Which pair of correlation coefficients would provide the BEST diversification benefit when added to the portfolio?
Pair A: Correlation of +0.95 with existing holdings
Pair B: Correlation of +0.45 with existing holdings
Pair C: Correlation of -0.20 with existing holdings
Pair D: Correlation of +0.10 with existing holdings
C is correct. Pair C with negative correlation (-0.20) provides the best diversification benefit. Negative correlation means when the existing portfolio declines, this asset is likely to rise (or decline less), reducing overall portfolio volatility. This inverse relationship maximizes the volatility-reduction benefits of diversification.
A (+0.95) provides minimal diversification because the securities move almost identically together, offering no volatility reduction. B (+0.45) provides moderate diversification but less than negative correlation. D (+0.10) provides good diversification with near-zero correlation, but negative correlation (Pair C) is superior because the assets actively offset each other's movements rather than just moving independently.
The Series 65 exam tests your ability to apply correlation analysis to portfolio construction decisions. Understanding that lower (and especially negative) correlation coefficients provide superior diversification benefits is essential for selecting securities that truly reduce portfolio risk rather than just creating the appearance of diversification.
All of the following statements about correlation are accurate EXCEPT
B is correct (the EXCEPT answer). This statement is FALSE. Securities with HIGH positive correlation provide POOR diversification benefits, not excellent ones. When securities are highly positively correlated, they move together in the same direction, so declines in one are accompanied by declines in the other, offering no volatility reduction. Effective diversification requires LOW or NEGATIVE correlation.
A is accurate: correlation coefficients are standardized measures ranging from -1.0 to +1.0. C is accurate: this is the fundamental principle of diversification, that combining assets with low or negative correlation reduces portfolio volatility. D is accurate: correlation measures co-movement but does not prove that one security causes the other to move; both might respond to a common factor.
The Series 65 exam tests whether you understand that high correlation is detrimental to diversification, not beneficial. This is a critical concept that students frequently confuse. Investment advisers must recognize that sector concentration or holding similar securities creates high correlation and defeats diversification objectives.
An investment adviser is analyzing correlation between different asset pairs for a diversified portfolio. Which of the following statements about correlation and diversification are accurate?
1. U.S. large-cap stocks and U.S. small-cap stocks typically have high positive correlation
2. Stocks and Treasury bonds typically have low or negative correlation, making them effective diversification partners
3. Two technology stocks with correlation of 0.05 would provide better diversification than two technology stocks with correlation of 0.85
4. A correlation of 0 between two securities means they are perfectly diversified
C is correct. Statements 1, 2, and 3 are accurate.
Statement 1 is TRUE: U.S. large-cap and small-cap stocks both respond to similar economic factors, interest rate changes, and market sentiment, resulting in high positive correlation. While not perfectly correlated, they provide limited diversification benefits relative to each other compared to adding bonds or international stocks.
Statement 2 is TRUE: Stocks and Treasury bonds have historically shown low or negative correlation. During equity market declines, investors often move to Treasury bonds for safety, causing bonds to rise while stocks fall. This inverse relationship makes them excellent diversification partners.
Statement 3 is TRUE: Correlation of 0.05 (near zero) indicates the stocks move independently, providing significant diversification benefits. Correlation of 0.85 (high positive) indicates they move together, providing minimal diversification. Lower correlation always improves diversification effectiveness.
Statement 4 is FALSE: Zero correlation (0) means no linear relationship exists, so the securities move independently. This provides good diversification, but "perfectly diversified" is not a precise term. Perfect negative correlation (-1.0) would provide maximum theoretical diversification benefit, not zero correlation.
The Series 65 exam tests comprehensive understanding of how correlation affects diversification across multiple scenarios. You must recognize typical correlation relationships between asset classes (stocks vs. bonds, large vs. small cap), interpret correlation coefficients correctly, and avoid overstating what correlation values mean for portfolio construction.
💡 Memory Aid
Think of correlation like dance partners: +1 = Move together (both step left together, no benefit), -1 = Move opposite (one goes left, one goes right, perfect balance), 0 = Move independently (doing different dances, good variety). For diversification, you want partners who DON'T move together (low or negative correlation), not partners who mirror each other (high positive correlation).
Related Concepts
This term is part of this cluster: