The misuse of Correlation Part 1 – Quick Refresher and Quiz

First, let’s refresh our memories of what correlation means.
This may seem very basic right now, but I would like to make sure the meaning is clear before we move on to its use.

I have included a question at the end, once you have read and thought about the definition:

A definition from the FT Lexicon: “a correlation is said to be positive if movements between the two variables are in the same direction and negative if it moves in the opposite direction.”

You can read examples in a number of sources such as

Here is a range of correlations, shown via a scatterplot:

Some important concepts

A positive correlation is “when the values increase together” An example would be temperature and ice cream sales as “warmer weather and higher sales go together”.

A negative correlation is “when one value increases and the other decreases”
Note this is sometimes called an “inverse correlation”.
An example would be weight of a car and its fuel efficiency as “cars that are heavier tend to get less miles per gallon.”

No correlation is when “there is no connection”. An example would be IQ and house number.”

For those of you with a more formal approach the mathematical formula for correlation is:

In practice, most of us find it much easier to use the function CORREL() in Excel!

Question time

Here is an example with two asset prices A and B. When we represent the data in a chart it can often be done in one of two ways.

This chart has two lines, showing how both the prices of asset A and B moved over time.

The other way to chart this is to put the prices of A and B on the two axes instead. It looks like this.

To make sure you have understood the basic concept of correlation, I would appreciate it if you could vote on an answer to the following question. (all anonymous of course!)

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