In investing, a negative correlation indicates that two stocks have prices that generally move in opposite directions from one another. Investors building a well-diversified portfolio frequently add stocks with a negative correlation so that if some parts of their portfolio are declining in price, others are rising.
Key Takeaways
- A negative correlation is when one variable moves in the opposite direction of another: one goes up, the other goes down, and vice versa.
- In investing, owning negatively correlated securities should mean that your losses are limited since when prices fall for one asset, they rise for another.
- A negative correlation between two stocks typically exists for fundamental reasons, such as different sensitivities to interest rate changes.
- Entire asset classes, e.g., stocks and bonds, can be negatively correlated.
For example, suppose Stock A ends the trading day up $1.15, while Stock B declined by $0.65. If this diametrical price action is a common occurrence over time, it is likely that these two stocks are negatively correlated.
What Is Correlation?
Correlation measures the degree to which two different variables are related to each other.Statistically, correlation can be measured from -1.00 to +1.00.
On one extreme, -1.00 represents a perfectly negative correlation: one variable goes down by exactly the number that another rises. The relationship is linear: change in one variable is proportionally related to the change in the other. Graphically, the data points for the two would form a straight line with a downward slope.
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 moves in relation to the other are random), the correlation will be exactly zero.
To determine whether there is a negative correlation between two stocks, you can use a spreadsheet app like Excel to run a linear regression on their stock prices by having one stock serve as the dependent variable and the other as the independent variable. The output will include the correlation coefficient, giving you a measure of how the two stocks move in relation to each other. Alternatively, you can use your online investing platform or online investment tools to do that work for you if you just put in the two stocks to compare. The number tells you how much the stocks move in opposite directions. The closer this number is to -1.00, the more they are negatively correlated.
Negative Correlation and Investing
Negative correlation is important for portfolios since it shows the benefits of diversification. Generally, you should try to include some negatively correlated assets to protect against volatility for your overall portfolio. Many stocks are positively correlated with each other and the overall stock market, making diversification using only stocks difficult.
Thus, you might look beyond the stock market for assets that are negatively correlated. Commodities have a higher likelihood of having a negative correlation with the stock market. Nevertheless, the amount of correlation between the prices of commodities and the stock market shifts over time.
Two stocks can be negatively correlated because they affect one another directly, or because they react differently to external stimuli. In the first case, take classic competitors like Coca-Cola and PepsiCo. Because the two have been historically locked in a battle for market share in the beverage sector, what is good for Coca-Cola may be bad news for Pepsi. For instance, a hot new product by Pepsi may boost its market share while co*ke falls. Therefore, close competitors in highly competitive markets may have a negative correlation. But this isn't always the case: a sudden shift in the market against soda drinks would likely affect both negatively.
Two stocks can be negatively correlated in reaction 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 sectors are hit particularly hard when this occurs.
Example of Stocks vs. Bonds
Historically, the asset classes of stocks and bonds have exhibited prolonged periods of negative correlation, although this need not always be the case. Hence, most financial professionals recommend a portfolio of both stocks and bonds.
Several hypotheses explain why bonds tend to rise when stocks fall, and vice versa. The first involves the flight to quality. When stocks become volatile or there's a bear market, investors may move their cash into more conservative investments, such as bonds.
At the same time, markets tend to fall during an economic recession, and interest rates also decrease at that time. As interest rates fall (along with stock prices), bond prices react inversely and rise.
Example of Negatively Correlated Stocks
We can observe negatively correlated stocks or industries that tend to move in opposite directions in response to the same market conditions. For instance, consider the relationship between a high-technology stock and a gold mining company.
It's important to note that positive or negative correlations are not fixed and can vary because of broader economic trends, company-specific news, and other factors. Investors can use these correlations to balance their portfolios, aiming to reduce risk by spreading their investments across different types of assets that have responded differently to the same economic conditions.
In general, technology stocks thrive during periods of economic growth and consumer confidence. People and businesses are more likely to invest in new technologies and upgrades when they feel financially secure. Meanwhile, gold is traditionally seen as a “safe haven.” During economic downturns or periods of market volatility, investors might flock to gold, driving up its price and those of gold-related stocks since it’s considered a more stable store of value.
Suppose the economy is booming, and consumer spending is high. In this scenario, tech companies might experience increased demand for their products, boosting their stock price. Still, during the same period, the appeal of gold would likely diminish, leading to a decrease in the price of gold stocks. Suppose the economy starts to falter or there are significant market uncertainties. In that case, the situation might reverse: tech stocks could decline because of reductions in consumer spending and corporate investment in technology. Meanwhile, the desire for gold could increase, resulting in a rise in gold stock prices.
Is Negative Correlation Good for Investors?
Negative correlation is a key concept in portfolio diversification. By including stocks that are negatively correlated, you can potentially reduce your overall portfolio risk. When one asset or sector performs poorly, another might be doing well, balancing the portfolio's performance and reducing the chance of losses.
How Can I Find Negatively Correlated Stocks or Assets?
You can find negatively correlated stocks or assets by analyzing historical price data and calculating the correlation coefficient. No need to break out your spreadsheets or graphing calculator: many financial websites and investment tools offer correlation calculators that compare the prices of different stocks over a given period. It's essential to analyze data over various market conditions to get a comprehensive view, as correlations can change over time. Past correlations do not necessarily predict the future; past associations can change from period to period.
Why Would Correlations Among Assets Change?
The correlation between assets can and ordinarily does change over time. Economic conditions, industry trends, and company-specific events can all influence how different securities move in relation to each other. For example, a technological advance might suddenly make a tech stock more positively correlated with an industrial stock if both benefit from the innovation. Or a change in regulations could negatively affect certain industries while favoring others, altering the previously established correlation patterns. For instance, stricter environmental regulations could harm the performance of traditional energy companies while boosting renewable energy stocks, leading to a shift in their correlation with other sectors. Similarly, geopolitical events like trade disputes or international sanctions can create new alignments or oppositions among various sectors and assets. These external factors can cause the correlations to fluctuate.
The Bottom Line
Negative correlation is when different securities move in opposite directions in response to similar market conditions. This phenomenon is influenced by a range of factors, including industry differences, economic cycles, market sentiment, monetary and fiscal policies, technological advances, and geopolitical events. Understanding these correlations is crucial for investors, especially for portfolio diversification and risk management. All the same, it's important to underline that these relationships are not static and can change. As such, this is another reason to remain vigilant and regularly reassess your strategies as you navigate the ever-evolving financial markets more effectively.
