Lesson 7 of 7 · 12 min

Limits of correlation analysis

A correlation coefficient is only as good as the data behind it: it misses non-linear links, bends to outliers, can be spurious, and never proves causation.

In short

  • Correlation measures only linear association; a strong curved relation can show a correlation near 0.
  • Outliers can create a high correlation or hide a real one; decide whether they are noise or information.
  • Correlation does not imply causation, however high it is.
  • Spurious correlation comes from chance, from dividing both variables by a common third variable, or from both depending on a third variable.
  • Identical means, standard deviations and correlations can hide very different data, so always plot the data.

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Limits of correlation analysis · Statistical Measures of Asset Returns