The concept of correlation is important for understanding the amount of diversification an investment offers. We can calculate it with the following. First, we have to calculate the pair of stocks covariance, which is just how much they move together: COV(Ra, Rb) = P [Ral - E(Ra)] [RE(R)] + P2 [Raz - E Note, the terms where we multiply the two different deviations rather than squaring the deviation of the single variable. Correlation is a just a "standardized" covariance in that we want it to be between 1 and +1. Consider the two following stocks, Stock A and Stock B: Scenario . || 11 |||| 31 percent 48 percent -4 percent -17 percent What is the covariance of Stocks A and B? IV Probability Stock A Return 0.20 0.30 0.30 0.20 Stock B Return 46 percent 35 percent -13 percent -7 percent