In that regard, a negatively correlated portfolio with significant volatility risk isn’t necessarily less risky than a positively correlated portfolio exposed with reduced volatility risk. High volatility can be associated with large price swings in either direction. That said, correlation is only one consideration of many when building a portfolio.įor example, volatility risk is the risk that the value of a financial instrument or portfolio will fluctuate unpredictably due to changes in the level of volatility in the market. This can lead to larger losses during market downturns. In contrast, a positively correlated portfolio may be more vulnerable to large swings in value, as the returns of all assets in the portfolio will tend to move in the same direction. This is because when one asset experiences a decline in value, the other asset may experience an increase in value, mitigating the overall loss in the portfolio. In a negatively correlated portfolio, the returns of one asset tend to move in the opposite direction of another asset, which can help to reduce the overall volatility of the portfolio. Portfolios that are negatively correlated can be less risky than portfolios that are positively correlated, as negative correlations can help to diversify and reduce overall portfolio risk. On the other hand, other market participants may prefer to have reduced positive correlation in their portfolios, and instead prefer a neutral or negative correlation among the underlyings in the portfolio. It’s possible that some market participants may prefer strong, positive correlation in their portfolios. Investors and traders can keep this in mind when building a portfolio. That suggests that a portfolio is theoretically better diversified when the correlations between the underlyings is neutral, or negative. On the other hand, negatively correlated underlyings move in opposite directions. In that regard, highly correlated underlyings don’t offer much in terms of portfolio diversification. In a portfolio, that means that highly correlated underlyings will move in the same direction, and often to the same degree. If two underlyings are highly correlated, that means they move in the same direction, to a similar degree. If it’s a strong negative correlation-such as the traditional link between interest rates and bond prices-then a move in one usually corresponds with an equal but opposite move in the other. Negative correlation indicates that two (or more) underlyings move in opposite directions. And if a correlation is exactly -1 or +1, it is generally referred to as a "perfect negative correlation" or "perfect positive correlation."Īside from those categorizations, correlations can also be characterized as weak, moderate, semi-strong, or strong-depending on the degree to which two (or more) underlyings are linked.įor example, -0.15 might be considered a "weak negative correlation," whereas -0.90 might be considered a "strong negative correlation."Īn understanding and awareness of correlation can provide investors and traders with important insight into movement in the financial markets-whether that be the relationship between different asset classes, or the relationship between underlyings within the same asset class. If no correlation exists between two securities, then the relationship is usually described as "zero" correlation. When two securities are negatively correlated-meaning they move in opposite directions-the correlation will range between -1 and 0. When two underlyings are positively correlated-meaning they move in the same direction-the correlation will range between somewhere 0 and +1.
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