What does perfectly negative correlation mean?

Question

I am reviewing for the CFP exam and my review materials suggest that you can create a risk-free portfolio consisting of two equally weighted and perfectly negatively correlated assets. This seems intuitive, but I found an article by Larry Swedroe suggesting that negative correlation doesn't mean that when one asset is up the other is down, it means that "when one asset experiences above average returns, the other tends to experience below average returns," which sounds like he means both assets can be up, just one is more up. Which is correct? Can you really create a theoretically risk-free portfolio from two perfectly negatively correlated assets (ignoring the fact that it would also be return-free)?

Answer 1

If one end of a seesaw goes up the other end goes down. That is a perfect negative correlation. It does not specify whether the entire board goes up or down, only one end relative to the other.



Many/most investors don't even know that much about the subject. They think "diversify" means to spread funds between any two different investments. Nope! Diversify means you don't know what you are doing, so you place a side bet that you think will go up if your main hope goes down, so you don't lose everything. There is no riskless portfolio. It is possible to guess wrong on your big investment and on your diversification too.

Answer 2

I don't know what exactly that Swedroe article said, but rest assured a perfectly negative correlation, a -1 correlation, means that if X goes up, then Y goes down, and they move oppositely 100% of the time. Anything other than that, then you have something less than a |1| correlation. If he's truly saying something other than that, he's wrong.



Yes, you can theoretically create a zero-risk, zero return port by picking two assets with -1 correlation. And no, you cannot do that in real life, both because transaction costs will interfere, and because you can't rely on the correlation remaining at -1.



(Of course you can equally say it's theoretically impossible to arrive at a zero-risk portfolio, because theory says it's impossible to find reliable -1 correlations without transaction costs ... so that gets kind of philosophical.)

Answer 3

Larry did not say anything about perfectly negative correlation. Because if the two variables negatively correlated,it will inversely move.Larry means only there are two assets.One is good asset,the other is bad.He did not mean that they are correlated perfectly.