Negative Correlation

What Is Negative Correlation?

Negative correlation is a relationship between two variables wherein one variable increases as the other decreases, and vice versa.

In statistics, a perfect negative correlation is represented by the value - 1.0, while a 0 demonstrates no correlation, and +1.0 shows a perfect positive correlation. A perfect negative correlation means the relationship that exists between two variables is precisely inverse constantly.

Understanding Negative Correlation

Negative correlation or inverse correlation demonstrates that two individual variables have a statistical relationship with the end goal that their prices generally move in inverse directions from each other. On the off chance that, for example, variables X and Y have a negative correlation (or are negatively correlated), as X increases in value, Y will decrease; similarly, in the event that X decreases in value, Y will increase.

The degree to which one variable actions in relation to the other is measured by the correlation coefficient, which evaluates the strength of the correlation between two variables. For instance, on the off chance that variables X and Y have a correlation coefficient of - 0.1, they have a weak negative correlation, yet assuming they have a correlation coefficient of - 0.9, they would be regarded as having a strong negative correlation.

The higher the negative correlation between two variables, the closer the correlation coefficient will be to the value - 1. All the same, two variables with a perfect positive correlation would have a correlation coefficient of +1, while a correlation coefficient of zero suggests that the two variables are uncorrelated and move independently of one another.

The correlation coefficient, generally indicated by "r" or "R", can be determined by regression analysis. The square of the correlation coefficient (generally signified by "R²", or R-squared) represents the degree or degree to which the variance of one variable is related to the variance of the subsequent variable, and is normally expressed in percentage terms.

For instance, if a portfolio and its benchmark have a correlation of 0.9, the R-squared value would be 0.81. The interpretation of this figure is that 81% of the variation in the portfolio (the dependent variable in this case) is related to — or can be made sense of by — the variation of the benchmark (the independent variable).

The degree of correlation between two variables isn't static, however can swing over a wide range — or from positive to negative, and vice versa — over time.

The Importance of Negative Correlation

The concept of negative correlation is a key one in portfolio construction. Negative correlation between sectors or geographies empowers the creation of diversified portfolios that can better endure market volatility and smooth out portfolio returns over the long term.

The building of large and complex portfolios where the correlations are carefully balanced to provide more predictable volatility is generally referred to as the discipline of strategic asset allocation.

Consider the long-term negative correlation among stocks and bonds. Stocks generally outperform bonds during periods of strong economic performance, yet as the economy dials back and the central bank reduces interest rates to invigorate the economy, bonds might outperform stocks.

For instance, expect you have a $100,000 balanced portfolio that is invested 60% in stocks and 40% in bonds. In a year of strong economic performance, the stock part of your portfolio could generate a return of 12%, while the bond part might return - 2% in light of the fact that interest rates are on a rising trend. In this way, the overall return on your portfolio would be 6.4% ((12% x 0.6) + (- 2% x 0.4).

The next year, as the economy eases back markedly and interest rates are lowered, your stock portfolio could generate - 5% while your bond portfolio might return 8%, giving you an overall portfolio return of 0.2%.

Imagine a scenario where, rather than a balanced portfolio, your portfolio was 100% equities. Utilizing the equivalent return presumptions, your all-equity portfolio would have a return of 12% in the first year and - 5% in the subsequent year, which are more volatile than the balanced portfolio's returns of 6.4% and 0.2%.

Equities and bonds generally have a negative correlation, however in the 10 years to 2018, their correlation has ranged from approximately - 0.8 to +0.2, according to BlackRock.

Instances of Negative Correlation

Instances of negative correlation are common in the investment world. A notable model is the negative correlation between crude oil prices and airline stock prices. Fly fuel, which is derived from crude oil, is a large cost input for airlines and essentially affects their profitability and earnings.

In the event that the price of crude oil shoots up, it could adversely affect airlines' earnings and thus on the price of their stocks. Yet, on the off chance that the price of crude oil trends lower, this ought to support airline profits and therefore their stock prices.

Here's the means by which the presence of this phenomenon can help in the construction of a diversified portfolio. As the energy sector has a substantial weight in most equity indices, numerous investors have huge exposure to crude oil prices, which are ordinarily very unstable. As the energy sector, for clear reasons, has a positive correlation with crude oil prices, investing part of one's portfolio in airline stocks would provide a hedge against a decline in oil prices.

Special Considerations

It ought to be noticed that this investment thesis may not work constantly, as the average negative correlation between oil prices and airline stocks could infrequently turn positive. For instance, during an economic boom, oil prices and airline stocks may both rise; conversely, during a recession, oil prices and airline stocks could slide in tandem.

At the point when negative correlation between two variables breaks down, it can play ruin with investment portfolios. For instance, US equity markets experienced their worst performance in a decade in the fourth quarter of 2018, partly fueled by concerns that the Federal Reserve (Fed) would keep on raising interest rates.

Fears of rising rates additionally negatively affected bonds, leading their normally negative correlation with stocks to fall to the weakest levels in decades. At such times, investors frequently discover to their chagrin that there is no place to stow away.

Features

• Negative or inverse correlation describes when two variables will generally move in inverse size and direction from each other, to such an extent that when one increases the other variable decreases, and vice-versa.
• Negative correlation is put to utilize while constructing diversified portfolios, with the goal that investors can benefit from price increases in certain assets when others fall.
• Correlation between two variables can vary widely over time. Stocks and bonds generally have a negative correlation, however in the 10 years to 2018, their measured correlation has ranged from - 0.8 to +0.2.