What is inverse correlation? Introduction, types & more


## **Introduction**

Inverse correlation, or negative correlation, means that when one variable is high, the other variable is likely to be low, and vice versa. It's like they move in opposite directions.

For instance, let's say we have two variables: A and B. When A has a high value, B tends to have a low value. And when A has a low value, B tends to have a high value.

In statistics, an inverse correlation is often measured using a number called the correlation coefficient, denoted by "r." The correlation coefficient ranges from -1 to 0. A value of -1 indicates a perfect inverse correlation between the two variables.

## **Types of correlation in investments**

When it comes to investments, correlation refers to how two variables are connected to each other.

Positive correlation means that the variables move in the same direction. For instance, if one variable goes down, the other variable also tends to go down. They have a similar behavior.

On the other hand, negative correlation, also called inverse correlation, means that the variables move in opposite directions. For example, when the stock market goes up, the value of a bond may go down. They have opposite behaviors.

To measure the strength of the relationship between two variables, we use a correlation coefficient. This coefficient ranges from -1 to 1. A correlation coefficient of -1 represents a perfect negative correlation, while a coefficient of 0 indicates no correlation at all. A positive correlation has a coefficient between 0 and 1, where a coefficient of 1 signifies a perfect positive correlation.

## **Graphing inverse correlation**

You can use a scatter diagram to visually check the relationship between two sets of data points. On the graph, one set of data is represented on the x-axis and the other set on the y-axis. By looking at how the points are distributed on the graph, you can determine if there is a positive or negative correlation.

In the case of a negative correlation, the points on the scatter diagram will generally form a downward sloping pattern. This means that as one set of data increases, the other set tends to decrease. This pattern suggests an inverse relationship between the two variables.

**In the provided graph, you can see a strong inverse correlation. As the values on the x-axis increase, the values on the y-axis consistently decrease. This shows a clear negative relationship between the two sets of data points.**

![Graph showing strong inverse correlation between data sets](https://hedonova.b-cdn.net/Hedonova%20images/%20All%20Hedonova%20blogs/What%20is%20inverse%20correlation%20Introduction%2C%20types%20%26%20more/what-is-inverse-correlation-1-min.webp)

## **What does inverse correlation tell you?**

By analyzing correlations, valuable insights can be gained about the connection between two variables, such as the tendency for the stock and bond markets to move in opposite directions.

The correlation coefficient is often used as a predictive tool to estimate metrics like the benefits of diversifying a portfolio to reduce risk. When returns on two different assets have a negative correlation, including them in the same portfolio can provide a balancing effect.

In the realm of financial markets, a well-known example of inverse correlation is seen between the U.S. dollar and gold. As the U.S. dollar weakens against major currencies, the price of gold generally rises, whereas when the U.S. dollar strengthens, the price of gold typically declines.

## **Negative, positive, and low correlation examples**

Consider the following graph depicting a negative correlation. As depicted below, the line equation is y = -0.8x. This implies that whenever Stock Y experiences a 1.0% increase, Stock X will invariably undergo a corresponding 0.8% decrease. This unyielding connection demonstrates a perfectly inverse relationship, where the movements of the two stocks consistently unfold in opposing directions.

![Graph showing perfect negative correlation](https://hedonova.b-cdn.net/Hedonova%20images/%20All%20Hedonova%20blogs/What%20is%20inverse%20correlation%20Introduction%2C%20types%20%26%20more/what-is-inverse-correlation-2-min.webp)

Now, let's examine a graph exhibiting a perfect positive correlation. In the graph below, it is evident that when Stock Y experiences a 1.0% increase, Stock X also demonstrates a corresponding 1.6% increase.

![Graph showing perfect positive correlation](https://hedonova.b-cdn.net/Hedonova%20images/%20All%20Hedonova%20blogs/What%20is%20inverse%20correlation%20Introduction%2C%20types%20%26%20more/what-is-inverse-correlation-3-min.webp)

Lastly, let's consider another example that depicts two assets with low correlation. As observed in the graph, the data points are widely scattered, and none of them align with the line of best fit. In the case of these two stocks, there is minimal correlation between the return of Stock Y and the return of Stock X. Their movements are largely independent of each other, indicating a lack of synchronized behavior or interdependence.

![Graph showing low correlation](https://hedonova.b-cdn.net/Hedonova%20images/%20All%20Hedonova%20blogs/What%20is%20inverse%20correlation%20Introduction%2C%20types%20%26%20more/what-is-inverse-correlation-4-min.webp)

## **Benefits of negatively correlated assets in portfolios**

Understanding negative correlation is crucial for investors and analysts evaluating potential additions to their investment portfolios. In times of heightened market uncertainty, a key strategy is to rebalance portfolios by substituting securities that exhibit positive correlation with those displaying negative correlation.

This approach allows the movements of different assets within the portfolio to counterbalance each other, thereby reducing both risk and return. Once market uncertainty subsides, investors can consider closing these offset positions. An example of negatively correlated securities would be a stock and a put option on that stock, where the put option gains value as the stock price declines.

### Some examples of negative correlation assets

Here are some common examples of a negatively correlated relationship between assets:

- **Oil prices and airline stocks**
- **Gold prices and stock markets (most of the time, but not always)**
- **Any type of insurance payoff**


Inverse correlation, or negative correlation, means that when one variable is high, the other variable is likely to be low, and vice versa. It's like they move in opposite directions.


What is inverse correlation? Introduction, types & more

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