What is Negative Correlation?
Negative correlation in a stock portfolio is the relationship between two stocks in which one stock increases and the other decreases. The last few years have been times of high volatility so a negatively correlated portfolio is more important than ever.
You can use negative correlation to manage the risk in your portfolio, by combining assets to produce a low volatility portfolio. By using negatively correlated investments you can reduce the overall volatility of the portfolio.
As investors you face two types of risks: Systematic Risk and Unsystematic Risk
What is Systematic Risk?
Systematic risk is the entire risk of the market. Systematic risk – also known as undiversifiable risk – can impact the entire market. It’s both unpredictable and impossible to avoid altogether. Factors in systematic risk include things like interest rate changes, inflation and recessions. Can you think of a recent example of systematic risk? …….Ding Ding Ding! Yep, you guessed it: COVID-19. Who could have planned for that? Only those who use Sci-Fi novels to map out their lives might have had a clue.
What is Unsystematic Risk?
Unsystematic risk deals with a specific company or industry. It’s also known as diversifiable risk in terms of your portfolio, and through diversification you can manage Unsystematic Risk. An example here is business risk: a company you are invested in gains a new competitor in the marketplace and all of sudden loses market share to that company. Another example could be an airline stock you own… If all the pilots of that airline go on strike, that could have a negative impact on the stock.
Okay, so how does it work? If you are invested in the market you are going to face Systematic Risk, but Unsystematic Risk can be managed by creating portfolios with negatively correlated assets.
Example of Perfect Correlation – Home Depot & Lowes
Looking at the below two charts for Home Depot and Lowes, you’ll see that they are almost identical. Do you think these two companies are negatively correlated? Nope, they’re not. In lockstep, when Home Depot goes up so does Lowes — this is an example of perfectly correlated stocks. Should you have both of these in your portfolio? Well, that’s a more complicated question and it depends on what else resides in your portfolio. If you have a portfolio of two stocks only, it should not be made up of just Home Depot and Lowes.
Example of Negative Correlation – Home Depot & TLT
Look at the below two charts for Home Depot and the TLT (the TLT is an ETF of long term treasury bonds). You’ll see that the charts are almost opposite. When Home Depot goes up the TLT goes down, just like a see-saw. Should you have both of these in your portfolio? Well, you very well could. However – just a side note – if interest rates increase in the near future you would be better off having a short term bond ETF adjusted for inflation like STIP rather than the TLT.