Correlation is a measure of how closely two assets are related – if one goes up in value, what will happen to the other? It is important when it comes to choosing your investment as it can be a useful measure to help you reduce risk.

Two particular assets could have:

Negative correlation – assets are likely to move up and down in completely opposite directions when affected by the same market conditions.

For instance, high fuel prices may be good for oil companies, but not for airlines who need to buy the fuel. As a result it would be expected that the share price of one company would rise whilst the other would move in the opposite direction. Because of this effect it would be recommended that combining negative correlated assets in your portfolio would help reduce the risk to your money.

No correlation – assets move completely independently of each other in response to market influences – this is because there is no relationship between the assets. Generally speaking, most assets have some correlation, even if it is very low.

Positive correlation – assets are likely to move up and down in the same direction when affected by the same market conditions.
 
For instance, an increase in consumer spending is good for shops and also for airlines as people may spend more on luxury items and holidays. As a result it would be expected that the share price in these type of companies would rise. This is good news if the share prices rise, but bad news if the share prices drop below the price that they were originally purchased at, thus making a loss on both sets of shares.

By combining assets that have low or negative correlations in your portfolio you can help reduce the risk to your money.