Overview of Negative Correlation example
A negative correlation is a type of statistical measure which is used to describe the relationship between two variables. A negative correlation happens when one variable increases when the other decreases and vice versa. Assets with such characteristics are used by portfolio managers in order to diversify the portfolio, decrease or mitigate the risk.
Examples of Negative Correlation
Examples of Negative Correlation are as Follows:
Negative Correlation – Example #1
Let us look at an example. Let’s assume a portfolio manager invests in the financial industry sector. But in the past few months, the prices of these stocks have been falling due to changes made by the Fed. According to his analysis, the shares are going to tumble further and might also lead to a crash. He is not looking at selling these stocks and want to keep them as per his client’s long term goal.
But he realizes that he has not diversified his portfolio and has not managed any risk. He thinks of using assets with a negative correlation with the financial industries. Assets that have a negative correlation with stocks are gold. The portfolio manager then sells a portion of his investments in the financial sector and buys gold to take advantage of the negative correlation.
If he is not keen on selling even a part of his portfolio, the portfolio manager can also hedge his risk. Negative correlation can also be used for hedging purposes which in turn mitigates the risk. The manager can take offsetting positions; in this case, for example, he can take put options of the stocks of the financial services or even sell call options. Both of these are considered as negatively correlated assets.
Negative Correlation – Example #2
Lara is an investor looking to add shares of Amazon or Apple to her portfolio. Her portfolio mainly tracks the stocks from the S&P 500. Before buying it, she wants to do some analysis and look at stocks that will help her diversify her portfolio and, most importantly, not increase the systematic risk of her portfolio. In order to fulfill this, he plans to look at the correlation of both these stocks.
He finds out the prices of the last three years and calculates the correlation. The correlation of Apple with the index is -0.9 while her portfolio is -0.7. On the other hand correlation of Amazon with the index is 0.9 while with her portfolio is 0.2
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Looking at the above, Lara decides to add Apple to her portfolio based on the negative correlation.
Negative Correlation – Example #3
A finance student is given a sample of risk and return of multiple stocks and is asked to decide which one will be the best for his investor if he is given an opportunity to advise them. His client’s main goal is to mitigate risk and diversify his portfolio. He also has exposure to oil prices.
There are multiple factors he is looking at in parallels like risk, return, and correlation. Below is the list of stocks he has to select from
He looks at all these stocks and observes that the stock with the highest two returns, i.e. 12% and 15%, have a positive correlation with the portfolio. He wonders if this is the right choice. However, he observes that the correlation of Facebook with the market is 1.0 that is perfectly correlated. Then he looks at the market performance of the last year of the S&P 500.
Looking at the numbers, he understands that the market has had a good last year due to a positive global outlook. However, according to him, the current market conditions do not look the same. So if he buys Facebook and looking at the perfectly positive correlation, he concludes that when the market falls, the price of this stock is also going to get hampered. He, therefore, does not choose Facebook to invest in
Next, he looks at Shell; he is aware that the client has exposure to oil prices. With choosing this company, there will no diversification benefits. Keeping that aside he checks for the correlation. The correlation of 0.6 means that when the market goes up, the stock prices go up and vice versa. Looking at both these factors, he does the select shell.
Next, he looks at Vistara; even though the return is not the highest but can provide great diversification benefits. First, since it is an airline company when it is negatively correlated to the oil exposure, and second, the correlation with the market is -1, which means that when the market price goes up, the stock price goes down. Both of these things perfectly match his objective, and therefore he selects Vistara.
Negative Correlation – Example #4
In this example, let us look at some actual real-world scenarios of negative correlation.
The most common example is the price of the bonds and interest rates. As the interest rate increases, the price of the bond falls. In this case, the fixed interest bonds become worthless, but the price of actual money has already gone up.
One more classic example would be the price of oil and oil producers (BP, Shell). This is negatively correlated to the price of airline companies.
The above ones are logical and can be related to; however, there are some different ones too. For example, The price of the potato chip makers vs the price of the potato. The oil price vs the share price of consumer discretionary companies. One logic can be that as the prices fall, there is more income on hand or discretionary income in the hands of consumers to buy cosmetics and other products.
Another example is the price of the dollar vs the price of the debt of the emerging market. When the price of USD rises, the ability of the emerging market countries to repay their debt back falls, which in turn increases the chances of default. The correlation may not be perfectly negatively correlated.
Conclusion
There are both pros and cons of using the correlation method. However, while taking decisions, it is important that they should not be taken in isolation, and a decision should be used based on the results of all the methods.
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