The purpose of the correlation filter is to find stocks that historically do not move in the same direction.
What is Correlation?
According to Investopedia.com, correlation is a statistical measure of how two securities move in relation to each other. Correlation is computed as a coefficient and has a value that falls between –1.0 and +1.0.
A positive correlation means that the correlation coefficient is exactly 1. If two securities are positively correlated, when one security moves up or down, the other security moves in the same direction.
When two securities consistently move in opposite directions, they are negatively correlated. This would be measured from 0 to –1.0.
Zero (0) is no correlation and –1.0 is a perfect negative correlation, or opposite 100% of the time.
No correlation securities, or zero (0), move independently of each other with no apparent relationship.
You will find that a portfolio of investments that are uncorrelated will in many cases be highly diversified.
Most investors want to avoid a situation where the stocks in their portfolios move up and down together.
Let’s look at an example.
The Chart shows this theory:
These two stocks are negatively correlated.
While Genesco (GCO) was moving up during Feb – May 2018, Anglogld (AU) was moving down.
A portfolio with these two stocks is less volatile and is prone to less ups and downs, than the individual VQs for GCO and AU.
GCO has a VQ of approximately 32.4%, and AU has the VQ of approximately 34.04% at the time of this writing.
The Blue Line (a combination of both GCO amd AU) has a portfolio volatility quotient of approximately 26.08%
The PVQ of this portfolio, if we apply 50/50 weightings, is only 26.08%, which is less than the VQs of the individual stocks.
For more information on correlation, please review the following link from Investopedia.com