How to Calculate Correlation of Investment Returns

You've crossed all the T's and dotted all the I's in your beginning investment portfolio. You set aside a little money every month for mutual funds, you've maxed out your retirement account contributions, you've set up a Roth IRA and you have already begun to diversify.

Now that you have a solid portfolio, it's time to deepen your understanding not just of how everything works but how everything works together. Calculating the correlation of your investments' returns will help you do just that. In order to calculate the correlation, you will need the closing prices or non-stock asset values over the duration of time you intend to analyze.

In order to calculate the correlation of your investment returns, you will need to gather information related to the closing price or value of the assets in question.

Why it Helps

Essentially, correlation gauges the relationship or lack thereof between the returns of two different investments. It's measured by a range of -1.0 to +1.0, where the latter indicates a perfect correlation, and the former indicates a perfect negative correlation. In a perfect correlation, two investments will always change value in unison; in a perfect negative correlation, they'll always change value in opposite directions. Of course, perfect correlations of either type are virtually impossible, but the scale helps you get a read on relationships.

The utility of knowing correlation boils down to one word: diversification. The less correlated your investments are, the less chance of your entire portfolio suffering at the mercy of fickle market trends.

Unless you're an aspiring mathematician, the most accessible way to input the formula for asset correlation is via a spreadsheet program, such as Microsoft Excel.

You'll first need to gather the daily closing prices or the value of non-stock assets rated over a regular period of time for the two assets you wish to explore. For stock, you can grab these from free sites, such as Morningstar or Google Finance. No matter what type of investment you have, the greater the amount of historic values you can gather, the more accurate your result will be.