A negative correlation in the context of investing indicates that two individual stocks have a statistical relationship such that their prices generally move in opposite directions from one another. Investors looking to build a well-diversified portfolio will often look to add stocks with such a negative correlation so that as some parts of a portfolio fall in price, others necessarily rise.
For example, say Stock A ends the trading day up $1.15, while Stock B is declines by $0.65. If this diametric price action is observed to be a common occurrence over time, it is likely that these two stocks are negatively correlated.
- A negative correlation is observed when one variable moves in the opposite direction as another.
- In investing, owning negatively correlated securities ensures that losses are limited as when prices fall in one asset, they will rise to some degree in another.
- Negative correlations between two stocks may exist for some fundamental reason such as opposite sensitivities to changes in interest rates.
- Asset classes on whole, such as stocks and bonds, may also tend to be negatively correlated.
What Is Correlation?
Correlation measures the degree to which the movement of two different variables are associated with one another. Correlation is a statistical measurement using a scale from -1.00 to +1.00.
-1.00 represents a perfect negative correlation, where one variable falls by exactly the amount that another one rises. Meanwhile a correlation of +1.00 indicates a perfect positive correlation, where each variable moves in exact tandem. If two variables are not at all correlated (i.e. their movements are completely random or completely unassociated with one another), the correlation will be exactly zero.
To determine whether there is a negative correlation between two stocks, run a linear regression on the individual stock prices by having one stock serve as the dependent variable and the other as the independent variable. The output from the regression includes the correlation coefficient and shows how the two stocks move in relation to each other.
Negative Correlation and Investing
Negative correlation is an important concept in the construction of portfolios, as it defines the benefits gained from diversification. Investors should seek to include some negatively correlated assets to protect against volatility for the overall portfolio. Many stocks are positively correlated with each other and the overall stock market, which can make diversification with only stocks difficult.
Investors may need to look outside the stock market for assets that are negatively correlated. Commodities may have a higher likelihood of having a negative correlation with the stock market. However, the amount of correlation between the prices of commodities and the stock market shifts over time. One aspect of the degree of correlation between the stock market and commodities is volatility.
Two stocks may be negatively correlated because they experience negative feedback between one another directly, or because they react differently to external stimuli. In the first case, imagine two competitors such as Coca-Cola and PepsiCo. Because these two firms are locked in a battle for market share in the beverages sector, what is good for Coca-Cola may necessarily be bad news for Pepsi. For instance, a hot new product by Pepsi may boost its price while Coke falls. Therefore, close competitors in highly competitive markets may see negative correlation.
Another reason has to do with two stocks having generally opposite reactions to the same external news or event. For instance, financial stocks such as banks or insurance companies tend to get a boost when interest rates rise, while the real estate and utilities sector get hit particular hard given an interest rate increase.
Example: Stocks vs. Bonds
Historically, stocks and bonds as broad asset classes have exhibited prolonged periods of negative correlation (although this need not always be the case). This is why most financial professionals recommend a portfolio of both stocks and bonds.
The reason why bonds tend to rise when stocks fall, and vice-versa, can be explained by a number of hypotheses. The first involves a flight to quality. When stocks become volatile or experience a bear market, investors may seek to move their cash into more conservative investments, such as bonds. At the same time, markets tend to fall during periods of economic recession, and interest rates also will fall during a recession. As interest rates fall (along with stock prices), bond prices react inversely and will rise.