What is Negative Correlation?

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Definition:

In investing, a negative correlation between two assets is measured by the degree that their prices move in opposite directions from each other.

🤔 Understanding negative correlation

Negative correlation occurs when two variables move in opposite directions over a given time period. As one variable decreases, the other variable increases, and vice versa. In finance, assets such as stocks, bonds, and other securities may experience various degrees of negative correlation over different time frames — When one asset goes up, the negatively correlated one goes down, and vice versa. Assets that have negatively correlated characteristics may be helpful for portfolio managers who want to diversify a portfolio to mitigate risk. If there's a market downturn or volatility (rapid change in market prices), negatively correlated assets may help to offset loss in a portfolio without sacrificing opportunity.

Example

One example of negative correlation would be oil prices and airline stocks. One would expect that sustained high fuel costs would generally depress the profits of airlines, and thus their stocks’ values. An investor looking to hedge risk might want to balance some stocks that benefit from high oil prices with some stocks that are hurt by those same high oil prices. Those assets would have a negative correlation with each other.

Takeaway

Negative correlation is like an argument between variables...

When one says up, the other says down. Two assets that do the opposite of each other have a negative relationship. As asset A increases, asset B decreases. When asset A falls, asset B rises. This is why assets that have a negative correlation of some degree are sometimes used to diversify investment portfolios.

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What is negative correlation?

Negative correlation occurs when two variables move in opposite directions to each other. As one variable increases, the other variable decreases, and vice versa. Correlation is used in statistics and other fields to measure the relationships between variables.

For example, marketers would say there is an observable negative correlation between the sales of winter coats and a rise in temperatures. As the temperature increases, the sales of winter coats decreases.

Correlation is used in finance to study the relationships between different assets. Two assets with negative correlation (aka inverse correlation) move in opposite directions — when one asset goes down, the other goes up.

Investors seeking to diversify their portfolios to mitigate risk during market downturns or times of volatility (when rapid change occurs in the markets) may wish to incorporate assets with negative correlation into their portfolios.

To find out whether two assets are negatively correlated, you need time series data, such as two assets’ closing prices as a data set over a period of time.

In this chart, we can see a negative correlation between age and time spent on a new app. The X-axis (horizontal axis) represents age. The Y-axis represents time spent. When age goes up, time spent on the app goes down, and vice versa.

What is negative vs positive correlation?

In finance, correlation is the measurement of how two assets move in relation to each other. If the two assets are positively correlated, it means that when one asset increases in value, the other asset also increases in value — and when one asset decreases in value, the other asset decreases in value. But if two assets are negatively correlated, when one asset increases, the other asset decreases, and vice versa.

A scatter plot chart is useful for viewing the overall relationship between two variables. If data points are close together with little room between them, you should be able to draw a straight line where they cluster, showing that a strong correlation exists between them. If the data points spread out and are farther apart from each other, they don’t have a linear relationship (you can’t draw a straight line through the cluster of their plot points) — They either have a very weak correlation or no correlation.

The coefficient “r” (aka Pearson’s Correlation Coefficient) measures the degree of the relationship between two variables. In investing, correlation is measured by the degree that the prices of two assets move with respect to their means (their average prices). If the two assets move entirely together relative to their respective average prices (mean), the correlation coefficient (r) is +1, and they have perfect positive correlation.

If the two assets move 100% in opposite directions relative to their average price, the correlation coefficient (r) is -1, and the two assets have perfect negative correlation. If the correlation coefficient is zero, then the two assets have no observable correlation.

How is correlation calculated?

To measure correlation, we need to find a correlation coefficient (r) which requires a tangly bit of high-level math. Fortunately, we can do it rather quickly using a spreadsheet and the correlation function built into Excel or Google Sheets.

If you want to make your own scatter chart, follow these steps to pull in live data from two assets of your choice to see whether they correlate or not.

  1. Download the closing prices of two assets:=GOOGLEFINANCE(“TICKER”,”close”,today()-365,today()) Do this for each asset with their ticker name.
  2. Find the period daily returns of each of the two assets:=LN(B2/B3) where B2 is the most recent day’s closing price and B3 is the previous day’s closing price. (Your cell columns and rows will, of course, be different.) Click in the bottom right corner of the cell and drag down to get periodic daily returns for each date.
  3. Use the correlation function to find the correlation coefficient: In any open cell type =CORREL(C2:C251, E2:E251) where C is the column of periodic daily returns of one asset and E is the column of periodic daily returns of the second asset. This function will give you the correlation coefficient. (Again, your cell columns and rows will be different.
  4. Graph a scatter plot: Highlight the two columns of data. Click Insert→ Chart. Choose Scatter.

What is the importance of negative correlation?

Negatively correlated assets may be a helpful tool when building a diversified portfolio. A diversified portfolio can help hedge against risk. If there is a chance that one stock will drop, its negatively correlated stock should rise at the same time — This helps to buffer loss.

When portfolio managers build diversified portfolios, some look for investments whose returns haven’t always moved in the same direction. That way, if part of the portfolio declines, the rest of the portfolio may not decline as much — or may even grow.

If investors only chase low risk investments during high volatility periods or a market downturn, they may miss opportunities that higher risk growth stocks may offer. Instead of eliminating higher risk stocks, incorporating negatively correlated assets may be one approach to building a portfolio that both hedges risk and allows for the possibility for growth, depending on market conditions.

What is an example of negatively correlated stocks?

Some assets may be somewhat dependent on the value of other assets, which could cause the appearance of a negative correlation — such as oil prices and airline stocks. Airlines are highly dependent on fuel derived from crude oil. Generally, a fluctuation in oil prices can affect the financial position of transportation companies and airlines. But this doesn’t mean that crude oil prices and airline stocks are always negatively correlated. Other economic factors (airlines hedging in the futures market, for example) can come into play and interfere with a direct correlation between one asset and another.

Correlation doesn’t necessarily indicate causation (one thing causing another thing to happen). Just because two values move in the same or opposite directions doesn’t mean that one asset’s movement in one direction causes the other asset’s movement in any other direction. But it could mean that both assets share a common cause or are both temporarily affected by a current financial or global event.

How should I interpret a negative correlation?

How investors interpret negative correlation should be directly related to their investing timeframe, goals, and risk tolerance. Many stocks are positively correlated and move in the same direction as each other. If your portfolio holds stocks that move in the same direction as each other, you will be exposed to more significant losses if the market slips.

If you don’t have a high risk tolerance and would like more stability in your portfolio, portfolio managers might suggest adding assets to your mix that are negatively correlated to help hedge against the risk of volatility. Conversely, if you are more interested in growth, have a longer investing timeframe, and a higher risk tolerance, you may not want negatively correlated assets to water down the growth potential of your returns.

Some assets that appear to have a negative correlation over more extended periods may not always remain negatively correlated within shorter intervals. Portfolio rebalancing based upon what the market is doing is essential to keep a portfolio diversified in case negatively correlated assets change behavior.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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