Expert: Gina Boykin - 9/15/2009

Question
Hello,

I am a beginner in investing. I have read in a book that in order to reduce risk, one can invest in stocks that are negatively correlated. If this is the case, can I ask how an investor earns returns when one stock is going up while the other stock is offsetting his potential returns?

Also, what industries out there are strongly positively (.5 to 1) and negatively (-1 to -.5) correlated such that one should look out for when investing?

Thank you.

Answer
What they are basically talking about is diversification.  It is the reason why many people hold both stocks and bonds, because these can be negatively correlated. When you hear bad news reports, bonds rise (expecting that interest rates will go down to help the economy) but stocks plummet.  To be diversified, you can hold stocks in several different industries or hold different types of bonds (corporate, federal government, municipalities, etc) or hold a combination of stocks, bonds, CDs, futures, etc.  

Using this strategy, over the long term, you are more likely to have gains.  You forfeit any steep short-term gains in any one type of investment, but also avoid steep losses which can occur in any one type of investment.

Another example of negative correlation would be related to oil.  If you own stock or futures related to oil, you will do well when prices rise.  If you also owned stock in an industry heavily affected by oil prices, such as the airlines, you may see their stock decline during a long period of high oil prices.  However, oil prices will not cause a day-to-day change in the airlines' stocks because they already hedge against these fluctuations as a part of their operations.

I don't have any specific recommendations for negatively correlated industries, because I don't specifically look for this when making investment decisions.  This is something you will have to research, and the best way to do this would be to look at a particular industry that you already have a desire to invest in, and look for the correlation for that one industry.