Overview
As we pointed out, some assets can be negatively related in a portfolio and therefore, the concept should not be unfamiliar to investors.
Then at least if one part has fallen in value, others may not have done so and vice versa.
The other type of association is referred as negative association and is defined as one variable rises while the other falls.
Perfect negative correlation implies the fact that there is inverted relationship between two given variables.
By the time you reach a line graph, you would observe a downward trend.
As was previously mentioned on the topic of demand curve, price and quantity are usually inversely proportional.
These are nearly always downward sloping, reflecting the fact that consumers are not averse to buying more of a good or service as they are able to get it cheaper.
Key Takeaways
- Negative or inverse correlation is when two variables tend to move in opposite directions from one another: when one grows, the other shrinks and when one shrinks the other grows.
- It is used when designing a diversified portfolio so that the investors are able to enjoy higher prices in the other assets when the others decline.
- The relationships between two variables can be weak but they can differ significantly over some period.
- As a rule, stocks and bonds operate in the opposite directions. That is why traditional portfolios contain both.
- Investing in assets inversely related to each other reduces portfolio risk; it can also reduce possible return.
This is further categorized where -1.0 is an ideal negative correlation, + 0.0 shows no correlation at all and + 1.0 is the ideal positive correlation. This is always an upward sloping curve positively sloped, to portray the reality that producers are willing to bring to the market more of a product as prices rise.
Understanding Negative Correlation
Negative or inverse correlation indicates that two individual variables have prices that generally move in opposite directions.
If, for instance, variables X and Y have a negative correlation, as X increases in value, Y will decrease; similarly, if X decreases in value, Y will increase.
In statistical terms, a perfect negative correlation is represented by a correlation coefficient of -1.0.
This means that for every unit increase in one variable, there is a unit decrease in the other.
However, in most real-world scenarios, negative correlations are imperfect, meaning that while the general trend is downward, individual data points might not fit the trend exactly (as in the chart above).
Negative correlations are commonly observed in various fields, such as finance or economics, where there’s typically a negative correlation between the supply of a product and its price. As supply increases, prices tend to fall, and vice versa.
Negative Correlation and the Correlation Coefficient
If you’re going to get information on the (negative) relations between two things, it is the correlation coefficient that you’re going to use.
It is expressed in range of – 1.0 ÷ + 1.0. A coefficient of 1.0 actually means perfect positive correlation which means that two assets are completely jointly move in the same direction.
At the same time, if the calculated coefficient is -1.0, it means that there is perfectly negative movement, as the assets’ prices move in the opposite fashion.
Where the coefficient is zero, there is no visible synchronization between the fluctuation of the two assets.
To investors these numbers may be very significant since they are useful in management, portfolio and risk dealing.
A diversified portfolio is generally, tried to be invested in assets that are little or negatively related to each other.
It can assist to reduce a general portfolio level of risk because losses in a single asset might be compensated by gains in another.
However, it should be remembered once again that no discovering tool in finance does not have limitations and the is true for correlation coefficient as well.
It assumes linearity only and can be info upended a lot by outlawyers present in the data set.
Also, these optimized results and correlations do not establish causation between current and future performance and past performance does not always predict future performance.
Watching for Outliers
An outlier in financial data is a figure that is numerically radically different from the other observations within a given set of data.
They may arise due to abberations in the market, inaccurate data, or truly unique circumstances.
For instance, if we are comparing the S&P 500 daily index returns and that of a specific tech stock for the past one year.
Daily volatility is low; the stock also fluctuates like the market most of the days, as it gives negative percentage of return between -2% and +2%.
However, one day the following occurs:
S&P 500 return: +0.5%
Tech stock return: +30%
This 30% increase in the tech stock probably resulted from some other factors such as: news breakthrough in the manufacture’s products.
Such a single day boost will increase the average return of the tech stock and make an erroneous assumption regarding relations between the stock and the market.
That is, if we were to compute the coefficient of correlation including this point, then the actual relationship between the stock and the S&P 500 on most trading days has a stronger negative coefficient of correlation than presented here.
More broadly, it means being vigilant for moments at which the regularity of trading operations may not be well reflected in the data.
Negative Correlation and Investing
To the investors negative correlation means that two assets when priced have the ability to move in the opposite direction.
What is more, it has been discovered that when the value of one of them is high, the value of the other is low and vise versa.
Inversely related means that in its application one can take use of risk diversification to its optimum for building up portfolios.
Two major uses in finance and investing:
Managing risk and diversification
Portfolio investors can also avoid the overall volatility by including the negatively correlated assets in it.
Because one investment may gain less value or even depreciate, another may gain value or depreciate less so as to cushion the impact.
Hedging
When selecting portfolio assets investors seek to hedge their potential money losses by balancing them equally with negatively correlated assets.
Examples of assets traditionally said to be negatively correlated
Stocks and bonds
That’s because investors tend to run for safer ground, and this may include buying more bond in case stock prices go down.
Gold and the U.S. dollar
Gold prices usually go up when the US dollar is low (as in the period beginning first half of 2020 and late 1970s).
Defensive stocks and cyclical stocks
Cyclicals such as the technology industry are often worse off when defensive industries such as utilities are better off.
However, it is claimed that these are true, when in fact it may be useful to examine the data first to look for how much of an impact the correlation has over time.
Below, we’ve made a correlation table of many of the larger assets in portfolios: Of course, there are positive correlations, although few are negative, and not strongly so, especially provided that the asset classes are diverse within a class and compared were compared.
Limits of Using Correlations to Build a Portfolio
Correlation is indeed an important input in building the efficient portfolio;
but a sound strategy for investing also takes into consideration the diversification with asset allocation, risk profile, time horizon and financial objectives.
While low or negative correlation can help reduce portfolio risk in certain circumstances, the assets may also have correlations closer to zero may also mean that the assets may also underperform.
Besides, such factors as liquidity, market conditions and general economic outlook may assume much larger importance in weighting the choice of assets to be included in a portfolio.
Other potential limitations of using asset correlation all on its own
Markets change
That is, correlations are not fixed due to change in market characteristics, business cycles, or political events.
Markets change aren’t static, given shifts in market conditions, economic cycles, or geopolitical events.
An asset pair that has shown a low or negative correlation in the past may become more correlated during market stress periods, reducing diversification’s effectiveness.
Therefore, an important step in the process is to examine the current state of asset interdependencies rather than relying on the adage that says stocks and bonds should always be in a portfolio.
Assumes a linear relationship
Correlation measures the extent of a straight-line relationship between two assets only.
However, many assets may have complex, nonlinear relationships that correlation fails to capture, potentially missing important aspects of their interaction.
Many assets may not perform in a linear manner and so correlation may omit crucial aspects of interaction between the assets.
Doesn’t Capture Volatility
The correlation coefficients do not yield a measure of the extent to which the asset prices change in value.
Assets can be uncorrelated but if one is very uncertain, it can deplete much of portfolio risk.
Correlation doesn’t give you any information about the magnitude of asset price movements.
Two assets might have a low correlation, but if one is highly volatile, it could still contribute significantly portfolio risk.
Therefore, correlation and volatility measures including the standard deviation should be used well.so considers asset allocation, risk tolerance, time horizon, and financial goals.
While low or negative correlations can help cut portfolio volatility, they may also limit potential returns should the assets with correlations closer to zero underperform.
In addition, liquidity, market conditions, and economic outlook often play a bigger role in determining which assets to include in a portfolio.
Here are some other drawbacks to using asset correlations in isolation from others
History isn’t the future
Correlation, often represented by a correlation coefficient, is normally established using past data which can be quite misleading in the present or future contexts.
Asset class diversification
Incorporation of correlation aims at the degree of co-varying between and among the sets of assets but neglects the aspects of diversification both by the classes of assets, business sectors and geographical locations.
It is possible to find a portfolio with low correlations between assets within one class while still be under-diversified if it invests in this class only.
FAQ’s
1. What it means by negatively correlated assets?
It simply means that as the values of these assets increases, the values of the other assets in the portfolio decreases and vice versa.
The negatively correlated assets therefore means if one of the assets is on the upward guess, then certainly the other is dropping.
2. In what ways does negativity in the asset mean lower risk portfolio?
By doing so they balanced the realizations from one asset with losses in another in a way that leveled out fluctuations.
3. Is it a fact that stocks and bonds are always inversely linked?
No; they can be inversely related during certain economic conditions but their relation has been inversely related during periods of market decline.
4. Is it possible for correlation between assets vary in the future?
Indeed, these correlations can be somehow opportunistic because correlations can change depending on the fact that the market, interest rates or any other economic policy.
5. Is gold always adversely sensitive to equities?
As we would expect, gold has an inverse relationship with risk, even though in stable periods it can have varying positive correlation with equities.
6. What is the way to quantify correlation of the assets?
If correlation is expressed between two parameters, then it is carried out by utilizing statistical characteristics, for instance Pearson correlation coefficient.
7. What are the disadvantages of negative correlation in assets?
If correlations do change, then the overly reliance on correlation assumptions, may itself prove costly. Moreover, negatively related assets may be considered as producing lower returns in a stable economy.
8. Should I always invest in negatively correlated assets?
That really depends on your level of risk and tolerance, your actual investment objectives, and your perspective on the market. Spread the risks is always good but spreading the risks too thin can actually bring harm to your pockets.
9. As much as we know about positively correlated assets, is there something that is said about specific classes of assets that move in a negative direction?
Yes, it includes few like stocks to bond, equities to gold and specific pairs of currencies.
10. What relationship between two variables can be characterized as different from negative correlation?
A form of diversification is the distribution of investment among many different securities so that the risks involved are small while negative correlation deals with assets that perform in an opposite manner.