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Examples of Negative Correlation

There is a negative correlation between outdoor temperature and heating bills, with a correlation coefficient of -0.96. This means that as temperature decreases, heating bills increase. Investments with negative correlations can help diversify a portfolio by reducing volatility. For example, a balanced portfolio with stocks and bonds will have less volatility than an all-stock portfolio because bond returns may move in the opposite direction of stock returns. The linear correlation coefficient measures the strength and direction of the linear relationship between two variables, ranging from 1 to -1. Software like Excel is often used to calculate correlation coefficients rather than doing it manually.

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Jennie Ruby
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34 views

Examples of Negative Correlation

There is a negative correlation between outdoor temperature and heating bills, with a correlation coefficient of -0.96. This means that as temperature decreases, heating bills increase. Investments with negative correlations can help diversify a portfolio by reducing volatility. For example, a balanced portfolio with stocks and bonds will have less volatility than an all-stock portfolio because bond returns may move in the opposite direction of stock returns. The linear correlation coefficient measures the strength and direction of the linear relationship between two variables, ranging from 1 to -1. Software like Excel is often used to calculate correlation coefficients rather than doing it manually.

Uploaded by

Jennie Ruby
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Examples of Negative Correlation

For example, suppose a study is conducted to assess the relationship between


outside temperature and heating bills. The study concludes that there is a
negative correlation between the prices of heating bills and the outdoor
temperature. The correlation coefficient is calculated to be -0.96. This strong
negative correlation signifies that as the temperature decreases outside, the
prices of heating bills increase (and vice versa).

When it comes to investing, a negative correlation does not necessarily mean


that the securities should be avoided. The correlation coefficient can help
investors diversify their portfolio by including a mix of investments that have a
negative, or low, correlation to the stock market. In short, when reducing volatility
risk in a portfolio, sometimes opposites do attract.  

For example, assume you have a $100,000 balanced portfolio that is invested
60% in stocks and 40% in bonds. In a year of strong economic performance, the
stock component of your portfolio might generate a return of 12% while the bond
component may return -2% because interest rates are rising (which means that
bond prices are falling). Thus, the overall return on your portfolio would be 6.4%
((12% x 0.6) + (-2% x 0.4). The following year, as the economy slows markedly
and interest rates are lowered, your stock portfolio might generate -5% while your
bond portfolio may return 8%, giving you an overall portfolio return of 0.2%.

What if, instead of a balanced portfolio, your portfolio was 100% equities? Using
the same return assumptions, your all-equity portfolio would have a return of 12%
in the first year and -5% in the second year. These figures are clearly more
volatile than the balanced portfolio's returns of 6.4% and 0.2%.

Linear Correlation Coefficient


The linear correlation coefficient is a number calculated from given data that
measures the strength of the linear relationship between two variables, x and y.
The sign of the linear correlation coefficient indicates the direction of the linear
relationship between x and y. When r (the correlation coefficient) is near 1 or −1,
the linear relationship is strong; when it is near 0, the linear relationship is weak.

Even for small datasets, the computations for the linear correlation coefficient
can be too long to do manually. Thus, data are often plugged into a calculator or,
more likely, a computer or statistics program to find the coefficient.

The Pearson Coefficient


Both the Pearson coefficient calculation and basic linear regression are ways to
determine how statistical variables are linearly related. However, the two
methods do differ. The Pearson coefficient is a measure of the strength and
direction of the linear association between two variables with no assumption of
causality. The Pearson coefficient shows correlation, not causation. Pearson
coefficients range from +1 to -1, with +1 representing a positive correlation, -1
representing a negative correlation, and 0 representing no relationship.

Simple linear regression describes the linear relationship between a response


variable (denoted by y) and an explanatory variable (denoted by x) using a
statistical model. Statistical models are used to make predictions.

 
Simplify linear regression by calculating correlation with software such as Excel.

In finance, for example, correlation is used in several analyses including the


calculation of portfolio standard deviation. Because it is so time-consuming,
correlation is best calculated using software like Excel. Correlation combines
statistical concepts, namely, variance and standard deviation. Variance is the
dispersion of a variable around the mean, and standard deviation is the square
root of variance. 

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