Correlation is a measure of the strength and direction of relationships between random variables. Two variables will exhibit strong correlation if they both tend to move in the same direction (positive or negative) with similar magnitudes of movement. Two variables will exhibit strong negative correlation if they move in opposite directions with similar magnitudes of movement.

Ideally, the goal for long term investors would be to find securities that each have high expected long term rates of return and that do not correlate strongly with each other. If we illustrate an example using two separate hypothetical stocks as depicted in the figure below, we see that both Sample Stock 1 and Sample Stock 2 are trending positively over time, however with different patterns of return. By combining both stocks together into a portfolio we see that the return variance of the combined portfolio is less than the return variance for either individual stock while the long term rate of return has not been compromised.

(You can click on the figure for a larger view)

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