One variable rises, another falls
One variable rises, another falls
A negative correlation is a relationship between two variables that move in opposite directions. In other words, when variable A increases, variable B decreases. A negative correlation is also known as an inverse correlation.
Two variables can have varying strengths of negative correlation. A variable A could be strongly negatively correlated with B, and may have a correlation coefficient of -0.9. This means that for every change in unit of variable B, variable A experiences a decrease by 0.9. As another example, these variables could also have a weak negative correlation. A coefficient of -0.2 means that for every unit change in variable B, variable A experiences a decrease, but only slightly by 0.2.
Let’s start with a graph of perfect negative correlation. As you can see in the graph below, the equation of the line is y = -0.8x. What that means is if Stock Y is up 1.0%, stock X will be down 0.8%. This relationship is perfectly inverse as they always move in opposite directions. Learn more about this in CFI’s online financial math course.
Now let’s look at a graph with perfect positive correlation. In the graph below you can that if Stock Y is up 1.0%, Stock X is up 1.6%, and since they move in the same directory every time. Learn about correlations in CFI’s online financial math course.
Finally, let’s look at another example, this time two low correlated assets. As you can see, the dots that are very dispersed and none of them lie on the line of best fit. For these two stocks, there is almost no correlation between the return of Stock Y and the return of Stock X.
This is covered in more detail in CFI’s math for finance professionals course.
The concept of negative correlation is important for investors or analysts who are considering adding new instruments to their portfolio. When market uncertainty is high, a common consideration is rebalancing portfolios by replacing some instruments that have position correlation with those that have a negative correlation.
The portfolio movement offsets each other, reducing risk but also return. After the market uncertainty has diminished, investors can start closing offset positions. An example of a negative correlation instrument is a short-sell stock position, which gains as a stocks price falls.
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A pair of instruments will always have a coefficient that lies between -1 to 1. A coefficient below zero indicates a negative correlation. When two instruments have a correlation of -1, these instruments have a perfectly inverse relationship. If instrument A moves up by $1, instrument B will move down by $1.
In another example, if the correlation between the EUR/USD exchange rate and USD/CHF exchange rate has a coefficient of -0.85, for every 100 points the EUR/USD moves up, the USD/CHF will move down by 85.
Learn more about coefficients in CFI’s financial math course.
Here are some common examples of negative correlations between assets:
Thank you for reading CFI’s guide to inversely correlated assets in investing and finance. To keep learning more, CFI highly recommends: