![]() Numerous factors, such as merger talks between two companies or one firm expanding its product line to more closely resemble that of another, may result in such a situation. Since the rise in some stocks will likely mean a drop in others, such a portfolio exhibits mild gains as well as small losses.įurthermore, stocks that were negatively correlated in the past may start to behave independently of each other or begin to move up or down together. First, such a portfolio's profit potential is also limited. Investing in negatively correlated stocks certainly is an appealing idea as it reduces the risk of a portfolio. While this is great if things go well and they both advance, if things go sour, they could both have a bad month or year, resulting in financial ruin. If the stocks are positively correlated, on the other hand, they tend to rise and fall together. The gain in one stock is therefore likely to offset the loss in the other. This implies that when the price of one performs worse than usual, the other will likely do better than usual. Assume the portfolio consists of two stocks and they are negatively correlated. Doing so reduces the risk of catastrophic losses in the portfolio and helps the investor sleep better at night. When building a diversified portfolio, investors seek negatively correlated stocks. Today, even the smartest experts rely on computers to calculate these figures. Although the concept of correlation is straightforward, its precise measurement requires advanced math and mastering such concepts as correlation coefficients and R-Squared figures. When one is above average, the other tends to be below average. Rainfall and the sale of sunglasses are negatively correlated. Umbrella sales and rainfall are usually positively correlated, because when one is above average, usually the other is too. They are negatively correlated, if one tends to go down as the other rises. Two variables are positively correlated if a rise in one is usually associated with a rise in the other. Knowing basketball scores won't help guess umbrella sales. And following the drawdown, stocks rebounded by 8, and Treasuries fell during the rebound. For example, during the first half of 2008, U.S. On the other hand, umbrella sales and the number of points scored by your favorite basketball team are not correlated. As mentioned earlier, stocks and bonds have a negative correlation. If someone tells you what the weather was - measured in inches per square-foot - on a particular day, you can make an educated guess about umbrella sales, and that guess would be more accurate than just throwing dice to estimate umbrella sales. For example, the rainfall and umbrella sales in a city tend to be are correlated. When given the movements in one variable, you can make an educated guess about the other, if there is a correlation. Two variables are correlated if their movements are related to each other. With negatively correlated stocks, losses in one particular asset could be offset by gains in another. Although positively correlated stocks may improve profit potential, this comes at increased risk.
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