Negative Correlation

In the financial markets, correlation is a statistical measure that indicates the extent to which the prices of different assets move together. A positive correlation means that the prices of two assets tend to move in the same direction, while a negative correlation means that the prices of two assets tend to move in opposite directions.

Negative correlation indicates that two (or more) underlyings move in opposite directions. If it’s a strong negative correlation—such as the traditional link between interest rates and bond prices—then a move in one usually corresponds with an equal but opposite move in the other.

If two underlyings are highly correlated, that means they move in the same direction, to a similar degree.

In a portfolio, that means that highly correlated underlyings will move in the same direction, and often to the same degree. In that regard, highly correlated underlyings don’t offer much in terms of portfolio diversification.

On the other hand, negatively correlated underlyings move in opposite directions. That suggests that a portfolio is theoretically better diversified when the correlations between the underlyings is neutral, or negative.

Investors and traders can keep this in mind when building a portfolio. It’s possible that some market participants may prefer strong, positive correlation in their portfolios. On the other hand, other market participants may prefer to have reduced positive correlation in their portfolios, and instead prefer a neutral or negative correlation among the underlyings in the portfolio.

If a correlation is exactly -1, it is generally referred to as a "perfect negative correlation."

In the context of financial markets, a correlation coefficient of -1.0 between two assets means that they have a perfect negative correlation, and their prices move in the opposite direction all the time.

For example, if two stocks from the same sector had a correlation coefficient of -1.0, that would indicate that when one stock moves up, the other stock moves down by the same amount.

A correlation coefficient of -1.0 is rare in real-world financial markets because most assets are affected by multiple factors and events that can cause their prices to fluctuate independently of each other.

However, a high negative correlation coefficient, such as -0.8 or -0.9 is more common. This degree of negative correlation indicates that the two underlyings move in opposite directions most of the time, but there may be some deviations from this pattern.

In the financial markets, one type of correlation isn’t necessarily better than the other.

Correlation reports on the relationship between two (or more) underlyings, and therefore informs an investor or trader about the relationship that exists between those underlyings.

An understanding and awareness of correlation provides investors and traders with important insight—whether that be the relationship between different asset classes, or the relationship between underlyings within the same asset class.

It’s possible that some market participants may prefer strong, positive correlation in their portfolios. On the other hand, other market participants may prefer to have reduced positive correlation in their portfolios, and instead prefer a neutral or negative correlation among the underlyings in the portfolio.

Portfolios that are negatively correlated can be less risky than portfolios that are positively correlated, as negative correlations can help to diversify and reduce overall portfolio risk.

In a negatively correlated portfolio, the returns of one asset tend to move in the opposite direction of another asset, which can help to reduce the overall volatility of the portfolio. This is because when one asset experiences a decline in value, the other asset may experience an increase in value, mitigating the overall loss in the portfolio.

In contrast, a positively correlated portfolio may be more vulnerable to large swings in value, as the returns of all assets in the portfolio will tend to move in the same direction. This can lead to larger losses during market downturns.

That said, correlation is only one consideration of many when building a portfolio.

For example, volatility risk is the risk that the value of a financial instrument or portfolio will fluctuate unpredictably due to changes in the level of volatility in the market. High volatility can be associated with large price swings in either direction.

In that regard, a negatively correlated portfolio with significant volatility risk isn’t necessarily less risky than a positively correlated portfolio exposed with reduced volatility risk. In this example, elevated volatility exposure may pose a more significant risk to the portfolio than a high degree of positive correlation, because large price swings can lead to significant losses.

Ultimately, the level of risk in a portfolio depends on a variety of factors, including the types of assets held, the level of diversification, and the individual risk tolerance and investment objectives of the investor.

Therefore, it is important for investors to carefully consider their portfolio construction and risk management strategies to ensure that they are aligned with their goals and risk tolerance.

A negative correlation doesn’t refer to the strength of the correlation.

Instead, it’s the correlation coefficient which indicates the relative weakness or strength of the link between two or more underlyings.

When two underlyings are positively correlated—meaning they move in the same direction—the correlation will range between somewhere 0 and +1. When two securities are negatively correlated—meaning they move in opposite directions—the correlation will range between -1 and 0.

If no correlation exists between two securities, then the relationship is usually described as "zero" correlation. And if a correlation is exactly -1 or +1, it is generally referred to as a "perfect negative correlation" or "perfect positive correlation."

Aside from those categorizations, correlations can also be characterized as weak, moderate, semi-strong, or strong—depending on the degree to which two (or more) underlyings are linked.

For example, -0.15 might be considered a "weak negative correlation," whereas -0.90 might be considered a "strong negative correlation."

Correlation is typically expressed using a correlation coefficient, which has a value between -1 and +1.

A negative correlation coefficient means that the prices of two assets tend to move in opposite directions.

Correlations can also be characterized as weak, moderate, semi-strong, or strong—depending on the degree to which two (or more) underlyings are linked.

For example, -0.15 might be considered a "weak negative correlation," whereas -0.90 might be considered a "strong negative correlation."