Replies to post #30 on the Pragmatic Investor

[DonCarlson]

Hi Bob, ----- Correlations

Correlation is a measurement of the strength of the relationship between two stocks. Correlation measures the extent to which the movements of the issues are similar.

You might want to look at the charts of the examples below:
http://finance.yahoo.com/q/cq?s=VFINX%2c+VTSMX%2c+RYNVX%2c+RYURX%2c+ERTS%2c+PETM%2c+LLTC%2c+GNTX&....

High Correlation Issues
For example,
• Vanguard Index Trust 500 (VFINX)
• Vanguard Total market Index (VTSMX)

 
 	VFINX	VTSMX 
 VFINX	1.0000	0.9968 
 VTSMX		1.0000 
 

In this case, the correlation between VFINX/VTSMX is 99.68%, very high correlation. When stocks/funds are highly correlated and have about the same historical total returns, there is no point trying to trade both, since there’s not enough differential movement between the two to make it worth while to trade both.


Negative Correlation Issues
For example,
• Rydex Nova (RYNVX)
• Rydex Ursa (RYURX)

 
 	RYNVX	RYURX 
 RYNVX	1.0000	-0.9929 
 RYRUX		1.0000 
 

In this case, the correlation between RYNVX/RYURX is -99.29%, extremely low correlation. When stocks/funds have low correlation and/or are negatively correlated, there’s generally enough differential movement between the two to make it worth while to trade both.


So, if you select stocks which have a score of 7 or better, and a correlation of less than 50%, or there abouts, there will probably be enough differential movement between the two to make it worth while to trade both.
For example, ERTS, PETM, LLTC, GNTX all have a score of 7 or better, and their correlations are:

 
 	ERTS	PETM	LLTC	GNTX 
 ERTS	1.0000	0.5443	-0.0965-0.0653 
 PETM		1.0000	-0.01921 -0.6648 
 LLTC			1.0000	0.4426 
 GNTX				1.0000 
 

There is not a great deal of correlation between these stocks, so IMO, you could setup an AIM account for each of the stocks and trade them successfully.