To really get to grips with negative correlation, the story of Cathie Wood is illuminating.
Cathie Wood, founder and CEO of ARK Invest, started making headlines in 2020. That year, the ARK Invest family of funds delivered stunning returns thanks to their singular focus on disruptive innovation.
Most assets in ARK Invest ETFs were classified in the tech sector, where major advances in artificial intelligence (AI), electric vehicles, digital healthcare, and genomic research – among others – are developed. When tech stocks went up, Cathie Wood’s funds went up, too. But it didn’t occur to many investors that their shares could lose value just as quickly as they rose.
In 2022, the entire tech sector lost trillions in value, and so did ARK Invest ETFs. Wood’s flagship fund, ARK Innovation, was down roughly 65 percent by the end of the year. Over the course of that 12-month period, 20 of the fund’s top 25 positions lost more than half of their value. Of those 20, six decreased by 80 percent or more.
Seasoned investors were not surprised by the drop in ARK’s fund values. Any portfolio that is heavily concentrated in a single economic sector is at risk for extreme volatility.
While Cathie Wood appears comfortable with such swings, the dizzying highs and sickening falls aren’t right for everyone. Substantial declines in portfolio value can be particularly problematic when shorter investment horizons mean there is no time for the portfolio to recover.
The most successful investors prefer to stabilize their portfolios with a diverse mix of assets. They spread their holdings across various asset classes, economic sectors, geographies, and company sizes to ensure they don’t lose big when one sector experiences a crisis.
They build stability into portfolio design by choosing sectors that are negatively correlated. When one goes down, another goes up, reducing the likelihood of large changes in total balance. Of course, that brings up an important question: Which sectors are negatively correlated?
Which Sectors Are Negatively Correlated?
Energy prices are negatively correlated with a number of sectors because the cost of fuel and its impact on transportation expenses touches virtually every part of the economy. All goods sold must be transported to their final destination, whether by ship, train, plane, or truck.
Higher fuel prices make the cost of those goods higher, and some of that expense is passed along to buyers. The rest comes out of profits. That means a negative correlation between the energy sector and retailers, manufacturers, agricultural businesses, and similar. However, though that negative correlation is apparent, it pales in comparison to the negative correlation between energy and airlines.
Airplanes are expensive to keep in the air, primarily because of their fuel consumption. Unfortunately, there is a limit to how much of fuel price increases can be transferred to travelers in the form of higher fares.
The air travel industry is extremely competitive, and for the moment, it comes down to ticket prices. Consumers travel with the provider that offers the best bargain. Airlines that raise ticket prices run the risk of unsold seats, and a partially empty aircraft means financial losses.
In short, when energy prices go up, a number of other sectors go down. In some cases, the effect is barely noticeable, while in others, the impact is significant. For example, airlines, trucking companies, and aerospace companies experience the most serious effects from this inverse relationship. Interestingly, there is also a strong negative correlation between energy and casino gaming.
Interest rates are known to influence the stock market, but their influence can be either positive or negative depending on the sector. Financial services companies see their profits rise with higher interest rates which increases stock value, while companies that thrive in a low-interest rate environment lose value when those rates increase.
For example, any business involved in real estate struggles when interest rates go up. As a result, the real estate sector has a negative correlation with the financial services sector when interest rates are the underlying cause of changes.
That brings up a new question – do all correlated sectors move in lockstep, or does correlation have a range?
What Is Perfect Negative Correlation?
A positive correlation occurs when two sectors move up and down together. A negative correlation is just the opposite. When one goes up, the other goes down.
In a situation of perfect positive or perfect negative correlation, the two related sectors move together. When one goes up 50 percent, the other goes up 50 percent (positive correlation), or when one goes up 50 percent, the other goes down 50 percent (negative correlation).
However, in nearly all cases, the correlation isn’t perfect. For example, in a negative correlation scenario, one sector might increase by 50 percent, but the other falls anywhere from zero to 100 percent. This relationship is expressed in a range from -1.0 to 1.0, where perfect negative correlation is -1.0 and perfect positive correlation is 1.0.
Correlation is better described by its relative strength, bearing in mind that a correlation of 0 means there is no relationship at all.
Negative correlations that fall between -1.0 and -0.70 are typically considered the strongest, while negative correlations between –0.70 and -0.30 are more moderate. Moderate negative correlations are still useful for stabilizing portfolios, but they are less effective than those with a stronger relationship.
How Are Negative Correlations Used In Risk Management?
As mentioned, Cathie Wood is so confident in the promise of disruptive innovation that she is willing to risk substantial losses by investing heavily in a single sector. Wood believes that despite the 2022 drop in tech stocks, her funds will eventually recover and return value to shareholders.
Warren Buffett is often mentioned as a perfect contrast to Cathie Wood, and in many ways, that perception is accurate. Buffett doesn’t put his money into new, unproven technology. He prefers established companies that have a long history of reliable returns. However, when it comes to diversification, he and Wood have something in common.
Two famous Warren Buffett quotes on diversification include, “Diversification makes very little sense for anyone that knows what they’re doing,” and “Diversification may preserve wealth, but concentration builds wealth.” That sheds light onto the logic behind Buffett’s decision to put 40 percent of Berkshire Hathaway’s portfolio into Apple stock.
Wood and Buffett aside, most of the world’s best investors aren’t comfortable with overreliance on a single sector. They prefer to manage risk through diversification. That includes mixing negatively correlated assets. In some cases, that means stocks in negatively correlated sectors. In others, that means assets that are negatively correlated.
The most common example of negatively correlated asset classes is stocks and bonds. High–quality bonds are generally considered lower risk than most stocks, and their rates typically go up when the stock market goes down.
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