What is correlation?
A correlation is an expression of how strong the relationship between two variables is. For example, there might be a strong correlation between hot, sunny weather and the number of ice creams sold. If the two variables move in the same direction, it's a positive correlation. Alternatively, if they move in opposite directions it's called a negative correlation. If it's zero, then there's no relationship between them.
Where have you heard about correlations?
Correlations are looked at a lot by analysts and portfolio managers, because understanding correlations is part of managing risk. They are also frequently used in psychology to help see patterns in behaviour.
What you need to know about correlations...
Being able to spot correlations can help you weigh up and mitigate risks.
In simple terms, understanding correlations gives you insight into creating a portfolio, where, if something happens to the economy, the value of your investments won't all be affected in the same way at the same time. If for example, something impacts negatively how investors feel about holding shares, the value of shares in both large and small companies is likely to go down, but maybe not by the same proportion because investors might see larger companies as better able to ride out the downturn. So the change in value would show a strong but not perfect correlation. And this sentiment about share values may not affect commodities at all because people still have to eat, for example, so the price of wheat may be unaffected by what has happened to shares.
Some shares can move in correlation. If the price of oil goes up the value of oil companies is likely to rise too but transportation company stock falls, because of extra fuel costs eating into profits. So some investors use correlations to anticipate future market price directions.
You also need to remember that correlation doesn't mean causation. Just because two things react in the same or similar way to a particular set of circumstances it doesn't mean that one causes what happens to the other. For example, there was a strong correlation in the 20th century between the number of radios purchased and the number of people in asylums but getting a radio is not likely to send you to an asylum nor is going to an asylum likely to cause you to get a radio. These are independent events.