Positive Correlation: Definition & Examples
In the finance world, it’s important to understand the relationship between different variables. As well as understand how one thing can affect the other.
For example, if the country is having a cold and wet summer – then people will be more likely to buy plane tickets to hot destinations. And if you own stock in airline companies, this is something that you’d want to know.
That’s where positive correlation comes into play. But what exactly is positive correlation and why is it important?
Read on as we take a closer look at what you need to know about positive correlation.
Table of Contents
- A positive correlation is a relationship between two separate variables that move together in the same direction.
- A positive correlation will exist when one variable will decrease as the other variable decreases. Or when one variable will increase as the other increases.
- In the finance world, correlations can be used to describe how individual stocks move. This is in relation to the wider market.
- A common measure of market correlation will use the S&P 500 index as a benchmark.
- A beta of 1.0 will denote that the stock is perfectly in line with the S&P 500. A value that is higher than 1.0 denotes that the stock is more volatile. While lower values will indicate that the stock is less volatile.
What Is a Positive Correlation?
A positive correlation is a relationship that exists between two different variables that move in the same direction. It exists when one variable decreases at the same time as the other variable. Or when one variable increases and the other variable also increases.
Why Is Understanding Positive Correlation Important?
In the business world, a positive correlation can be used for showcasing the correlation between the demand for a product and the price associated with the product. So in situations where a product is readily available, the correlation between price and demand stays constant. But if demand increases, the price increases with it.
In the world of statistics, a perfect positive correlation can be represented by the correlation coefficient value +1.0. A value of 0 indicates that there is no correlation, and a -1.0 shows that there is a negative correlation. Also known as a perfect inverse.
When it comes to the market, gains or losses in specific markets can lead to similar movements in markets that are associated. For example, if the price of fuel increases, then the price of taxis could increase. Since cars require fuel to operate, the cost of this increase in price is often passed down to the customer. This leads to a positive correlation between fuel prices and the cost of a simple taxi ride.
A positive correlation doesn’t guarantee benefit or growth. It is simply showing that two variables are moving in the same direction together. But this correlation doesn’t always indicate a causal relationship between variables.
Correlation works with a degree of dependency. Where a shift in one variable will likely lead to a change in the other. Or that specific known variables can produce certain results.
A good example of this can be seen with what’s known as complementary product demand. This means that if the demand for one product rises, then the demand for complementary products will also rise. To give a simple example, let’s say that the demand for new housing goes up. Then the demand for complementary services such as construction materials will increase as well.
This positive correlation can also extend to psychological responses. Take the stock market, for example. If positive news is released about a certain stock, then the price of that stock is likely to rise.
What Is the Difference Between Positive Correlation and Inverse Correlation?
As we now know, a positive correlation is a relationship between two different variables that change as one. But an inverse correlation describes the relationship between two different variables that change and go in opposing directions.
Inverse correlations can also be described as negative correlations. It describes two separate factors that change in relation to each other. As one goes up, one goes down.
For example, if you buy expensive items your spending will rise. However, your bank balance will fall. The faster you drive your car, the faster your gas mileage will fall.
When it comes to the business world, you can see inverse correlation in investments. Specifically, the relationship between stocks and the bond market. As a stock price rises, the bond market will tend to decline. In the reverse, when a stock price falls, the bond market will tend to rise.
Correlation doesn’t always imply causation. While both variables may rise and fall together, it is not always true that one variable will directly affect the other. There may be an underlying third variable that causes the other two to move.
For example, the amount of people using the internet since its conception has risen over the years. During the same period of time, the price of oil has also risen. This is technically a positive correlation, even though the two variables have no particular meaningful relationship. They are both affected by an underlying variable, which is the general increase over time.
How To Calculate Positive Correlation
In mathematics, a positive correlation can be calculated using Pearson’s Correlation. Here is an example of how to use this calculation.
Let’s say that we have two sets of data, they are Set X and Set Y. Now follow these steps:
- Step 1: Find the mean of Set X and the mean of Set Y.
- Step 2: Subtract the mean of Set X from every X value. We will call these new values Set A.
- Step 3: Subtract the mean of Set Y from every Y value. We will call these new values Set B.
- Step 4: Calculate ab, a2 and b2 for every value.
- Step 5: Sum up ab, sum up a2 and b2.
- Step 65: Divide the sum of ab by the square root of [(sum of a2) x (sum of b2)]
Types Of Correlation
There are three different types of correlation. They are:
- Positive Correlation: This is when the values of two variables move in the same direction. An increase or decrease in the value of one variable will be inevitably followed by an increase or decrease in the value of the other variable.
- Negative Correlation: This is when the values of two variables move in opposite directions. This means that an increase or decrease in the value of one variable is inevitably followed by an increase or decrease in the value of the other variable.
- No Correlation: The third type of correlation is no correlation. This is when there is no linear dependence or no relationship between the two separate variables.
What Is an Example of Positive Correlation?
Let’s take a look at positive correlation in the stock market. Let’s say you take an individual stock and compare it to the wider market. If the beta value is greater than zero, then the stock would be positively correlated with the market. Meaning if the market rises, the share price will tend to rise with it.
If the beta value of the stock is less than zero, then its price movements will be smaller than the movements of the market itself. And finally, if you have a beta that is higher than 1.0, it indicates that the stock will fluctuate more than the wider market.
Positive correlation is a useful tool to track certain variables. As with anything, the more prepared you are the more likely you can spot certain correlations and make informed decisions.
In the business world, positive correlation can be used to measure stocks within the wider market. This is done by using beta as a measure and comparing it against the S&P 500 index as the benchmark.
FAQs on Positive Correlation
What Is Positive and Negative Correlation?
A positive correlation is two variables moving together in the same direction. A negative correlation is two variables moving together in separate directions.
What Is a Perfect Positive Correlation?
A perfect positive correlation is when the variables in question move together in exactly the same direction. And also at the exact same percentage 100% of the time.
What Is an Inverse Correlation?
An inverse correlation is the same as a negative correlation. This is where two variables move at the same time in opposing directions.
How Do You Know if You Have a Positive or Negative Correlation?
If the correlation coefficient is larger than zero, then there is a positive relationship. On the other hand, if the correlation coefficient is below zero, then there is a negative relationship.
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