Loading the player...

What is 'Negative Correlation'

Negative correlation is a relationship between two variables in which one variable increases as the other decreases, and vice versa. In statistics, a perfect negative correlation is represented by the value -1.00, a 0.00 indicates no correlation, and a +1.00 indicates a perfect positive correlation. A perfect negative correlation means the relationship that exists between two variables is negative 100% of the time.

BREAKING DOWN 'Negative Correlation'

Negative correlation is used in statistics to measure the amount that a change in one variable can affect an opposite change in another variable. Analysts perform a regression analysis to quantify predictability of the negative relationship between the two variables. This procedure provides analysts with a calculation of R-squared (R2), which is the statistical measure of how well one variable predicts the value of another variable. If the R2 between two separate items is 1, it means the independent variable accurately predicts the dependent variable without error. An R2 of 0 implies that the independent variable cannot predict the dependent variable. An R2 that falls between 0 and 1 measures the extent to which the independent variable predicts the dependent variable. For example, if R2 is 0.4, this implies that the independent variable can predict the dependent variable with 40% accuracy.

For example, the more time a person devotes to purchasing goods at the mall, the less money he will have in his checking account. The higher an investor's mutual fund expense ratio, the lower his investment returns. The more hours a person spends at the office, the less time he or she has for other activities. All of these variables have a negative R2.

The Importance of Negative Correlation

Negative correlation is important for any analyst, investor or person looking to diversify and hedge his bets. If an investor is able to find an investment class that moves opposite to another set of assets he is holding, he can invest in both to stabilize his portfolio. Commodities, for example, are known to move in the opposite direction of the stock market, on average. If an investor holds a portfolio with a 100% allocation of public equities, he can sell some of his stock to purchase precious metals, thus balancing his portfolio from volatility.

However, while negative correlation can be used to reduce the risk of a portfolio, it can also create a situation where an investor cannot win. If the two asset classes are perfectly negatively correlated, any gains in one class are completely offset by the other. Therefore, it is important to find two different investments that have a small, negative correlation. This way, if the relationship between stocks and commodities is -0.40, an investor can reduce, but not completely offset, his losses in times when stocks are moving downward and still earn a positive return when stocks increase in value.

RELATED TERMS
  1. Positive Correlation

    Positive correlation is a relationship between two variables ...
  2. Multiple Linear Regression - MLR

    Multiple linear regression (MLR) is a statistical technique that ...
  3. Variable Death Benefit

    Variable death benefit refers to the amount paid out at death ...
  4. Serial Correlation

    Serial correlation is the relationship between a given variable ...
  5. Current Index Value

    Current index value is the most current value for the underlying ...
  6. Endogenous Variable

    An endogenous variable is a classification of a variable generated ...
Related Articles
  1. Investing

    What's the Correlation Coefficient?

    The correlation coefficient is a measure of how closely two variables move in relation to one another. If one variable goes up by a certain amount, the correlation coefficient indicates which ...
  2. Investing

    What's a Sensitivity Analysis?

    Sensitivity analysis is used in financial modeling to determine how one variable (the target variable) may be affected by changes in another variable (the input variable).
  3. Investing

    Stock and Flow Variables Explained: A Closer Look at Apple

    The difference between stock and flow variables is an essential concept in finance and economics. We illustrate with financial statements from Apple Inc.
  4. Investing

    Diversification: Protecting portfolios from mass destruction

    This investing strategy retains its charm as a protection against random events in the market.
  5. Retirement

    Variable Annuities: The Do-It-Yourself Pension Plan

    Variable annuities can cost more than mutual funds, but that might be worth the protection they can add to your retirement.
  6. Financial Advisor

    Life Insurance: Variable Vs. Variable Universal

    Do you know why you might need one policy versus the other? Read on to find out the difference between Variable and Variable Universal life insurance.
  7. Investing

    Consider These Facts Before Choosing a Variable Annuity

    Variable annuities do have some benefits, but there are some disadvantages and misconceptions to take into account as well.
  8. Investing

    Scenario Analysis Provides Glimpse Of Portfolio Potential

    This statistical method estimates how far a stock might fall in a worst-case scenario.
  9. Tech

    Are Bitcoin Price And Equity Markets Returns Correlated?

    Is there a correlation between bitcoin's price and the equity markets? We investigate.
RELATED FAQS
  1. Does a negative correlation between two stocks mean anything?

    Learn what the concept of negative correlation means, understand how it is generally calculated and see how it is used in ... Read Answer >>
  2. What is the difference between direct costs and variable costs?

    Learn about variable costs and direct costs, how direct costs and variable costs are classified and the differences between ... Read Answer >>
Hot Definitions
  1. Business Cycle

    The business cycle describes the rise and fall in production output of goods and services in an economy. Business cycles ...
  2. Futures Contract

    An agreement to buy or sell the underlying commodity or asset at a specific price at a future date.
  3. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  4. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  5. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  6. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
Trading Center