negative correlation

Negative correlation is a statistical measure of how the values of two investments in a given portfolio are related to one another. Those with strong negative correlation tend to move in opposite directions, either rising or falling in direct contrast to its counterpart.

Negative correlation is also known as inverse correlation.

What does a negative correlation mean?

Here are examples of positive and negative correlation:

Infographic explaining the difference between positive and negative correlation.

When two assets are negatively correlated, as you see above, their prices move in opposite directions, to the same degree. If one drops $5 on a given day, the other gains $5.

The correlation coefficient

The correlation coefficient quantifies the degree of correlation between two variables. It’s represented as a range between 1 and -1:

• 1 = perfect positive correlation. The two variables move up and down in exact synchrony.

• -1 = perfect negative correlation. The two variables always move in opposing directions to the same degree.

• 0 = no correlation at all. A movement in one variable provides no insight to the movement of the other.

Negative correlation and diversification

Negative correlation is important factor in portfolio construction. A portfolio whose positions are all highly correlated to one another carries a high risk of losing value all at once.

One traditional diversification strategy in building a portfolio is to choose assets with very limited correlation to one another — either lightly positive, or even negative.

The lower the degree of correlation in a portfolio, the less likely it is to lose a significant amount of its value at once.