Negative correlation is a relationship between two variables where one increases as the other decreases, and vice versa. In statistics, a perfect negative correlation is represented by the value -1.0; 0 indicates no correlation, and +1.0 signifies a perfect positive correlation. A perfect negative correlation means the variables move in exactly opposite directions consistently.
Key Takeaways
- Inverse Movement: Negative or inverse correlation describes when two variables move in opposite directions such that when one increases, the other decreases.
- Diversified Portfolios: Investors use negative correlation to construct diversified portfolios, benefiting from price increases in certain assets when others fall.
- Variable Correlation Over Time: Over time, the correlation between two variables can change due to varying conditions.
- Stocks and Bonds: Traditionally, stocks and bonds have a negative correlation, suggesting that investors should hold both to minimize risk.
- Risk and Gain: Although negatively correlated assets can reduce portfolio risk, they may also minimize potential gains as these assets act as hedges against each other.
Understanding Negative Correlation
Negative correlation indicates a statistical relationship where the prices of two variables move inversely. If variables X and Y are negatively correlated, then as X increases in value, Y tends to decrease, and similarly, if X decreases, Y will increase.
Outside investments, negative correlation appears in other business and financial contexts:
- Household Income and Inferior Products: As household income increases, consumption of less premium goods decreases.
- HR Department Spending and Employee Retention: Lower spending on employee social events often increases employee turnover.
- Manufacturing Training and On-the-Job Injuries: More employee training results in fewer job-related injuries.
Negative correlation aligns with the learning curve: as more time is spent learning, task performance time decreases. Hence, as proficiency increases, rework or failure rates drop.
Negative Correlation and the Correlation Coefficient
The strength of the negative correlation between two variables is quantified by the correlation coefficient. For instance, if X and Y have a correlation coefficient of -0.1, they are weakly negatively correlated; a coefficient of -0.9 reflects a strong negative correlation.
The closer the negative correlation coefficient is to -1, the stronger the negative correlation. Conversely, a perfect positive correlation has a coefficient of +1, and a zero coefficient means the variables are uncorrelated.
The correlation coefficient, represented as “r” or “R”, is determined by regression analysis. Its square (R²) shows the extent of variance of one variable related to the other. For example, a portfolio with a 0.9 correlation to its benchmark has an R² of 0.81, meaning 81% of its variance can be explained by the variation in the benchmark.
Negative Correlation and Portfolio Diversification
Negative correlation is key in constructing diversified portfolios. By diversifying sectors or geographies that are negatively correlated, investors can create portfolios resilient to market volatility.
A historical example is the negative correlation between stocks and bonds. Stocks typically outperform during strong economic periods, while bonds shine when the economy slows down. Diversifying investments in stocks and bonds ensures strong asset performance regardless of economic conditions.
The ultimate goal is to find negatively correlated assets. This might extend beyond asset classes, where gold ETFs may act differently from physical gold. A well-diversified portfolio comprises negatively correlated assets, navigating economic shocks and ensuring stronger long-term returns.
Advantages and Disadvantages of Negative Correlation
Advantages of Negative Correlation
- Reduced Risk: Holding negatively correlated assets often decreases portfolio risk.
- Lower Volatility: Different industries can offset each other over time, reducing portfolio volatility.
- Engaging Strategy: Diverse investments often make investing more engaging for retail investors.
- Business Expansion: Companies benefit by offering non-competing product lines, maximizing revenue without cannibalizing product lines.
Disadvantages of Negative Correlation
- Misleading Correlation: Negative correlation might be misleading if interpreted wrongly. Correlation today might not hold tomorrow.
- Lack of Knowledge: Investors may hold assets outside their expertise, increasing risks they may not fully understand.
- Lower Returns: Focusing on negatively correlated assets might cap potential returns.
Negative Correlation at a Glance
Pros
- May reduce short-term risk
- May reduce long-term volatility
- Engages investors in diverse industries
- Promotes business expansion without product overlap
Cons
- Potentially misleading correlation data
- Exposure to unfamiliar asset classes
- Potentially lower returns due to diversification
Macroeconomics and Negative Correlation
Investment strategies based on negative correlation are not foolproof. The usual negative correlation between oil prices and airline stocks might turn positive during an economic boom or recession. Systematic risk, inherent in financial markets, can’t be diversified away, and negatively correlated asset classes might move in the same direction under specific macroeconomic conditions.
Example of Negative Correlation
A classic investment example is the negative correlation between crude oil prices and airline stocks. Jet fuel, a major cost input for airlines, impacts their profitability and earnings. When crude oil prices rise, airline profitability and stock prices generally fall, and vice versa. Including airline stocks in a portfolio with significant exposure to the energy sector can hedge against oil price declines.
Why Is Correlation Important?
Correlation is vital in assessing portfolio risk. Negatively correlated securities pose less risk since a fall in one security’s value may be mitigated by a rise in another. Conversely, investors seeking higher potential returns may focus on positively correlated securities to maximize risk and reward.
How Is Correlation Calculated?
Correlation is calculated by finding the covariance of each variable pair and dividing it by the product of the variables’ standard deviations.
Types of Correlation
There are three main types of correlation:
- Positive
- Negative
- No Correlation
Additionally, several methods to calculate correlation include Pearson correlation, Kendall rank correlation, Spearman correlation, and Point-Biserial correlation.
Is Negative Correlation Better Than Positive Correlation?
For some investors, negative correlation is preferable due to lower risk exposure, investment variety, and reduced portfolio volatility. However, it may also limit potential gains by hedging investments.
The Bottom Line
Negative correlation describes an inverse relationship where one variable’s increase corresponds with the other’s decrease. This relationship is fundamental to portfolio diversification theory, favoring a mix of negatively correlated assets to minimize risk.
Related Terms: inverse correlation, positive correlation, portfolio diversification.
