A:
statistics, a perfect negative correlation is represented by the value -
Positive correlation exists when two variables move in the same
direction. A basic example of positive correlation is height and
weight—taller people tend to be heavier, and vice versa. In some
cases, positive correlation exists because one variable influences the
other. In other cases, the two variables are independent from one
another and are influenced by a third variable. The field of economics
contains many cases of positive correlation. In microeconomics,
demand and price are positively correlated. In macroeconomics,
positive correlation exists between consumer spending and gross
domestic product (GDP).
Postive Correlation in Microeconomics
Microeconomics, which analyzes individual consumers and firms,
features many instances of positive correlation between variables, one
of the most common being the relationship between demand and price.
When students study microeconomics and statistics, one of the first
concepts they learn about is the law of supply and demand and the
influence it has on price. The supply and demand curve shows that
when demand increases without a concomitant increase in supply, a
corresponding increase in price occurs. Similarly, when a demand for a
good or service decreases, its price also drops.
The relationship between demand and price is an example of
causation as well as positive correlation. An increase in demand
causes the corresponding increase in price; the price of a good or
service increases precisely because more consumers want it and
therefore are willing to pay more for it. When demand decreases, that
means fewer people want a product and sellers must lower its price to
entice people to buy it.
In contrast, supply is negatively correlated with price. When supply
decreases without a corresponding demand decrease, prices increase.
The same number of consumers now compete for a reduced number
of goods, which makes each good more valuable in the eye of the
consumer.
Macroeconomics
Positive correlation also abounds in macroeconomics, the study of
economies as a whole. Consumer spending and GDP are two metrics
that maintain a positive relationship with one another. When spending
increases, GDP also rises as firms produce more goods and services
to meet consumer demand. Conversely, firms slow production amid a
slowdown in consumer spending to bring production costs in line with
revenues and limit excess supply. (For related reading,
see: Macroeconomics: Supply, Demand and Elasticity.)
Like demand and price, consumer spending and GDP are examples of
positively correlated variables where movement by one variable
causes movement by the other. In this case, consumer spending is the
variable that effects a change in GDP. Firms set production levels
based on demand, and demand is measured by consumer spending.
As the level of consumer spending moves up and down, production
levels strive to match the change in demand, resulting in a positive
relationship between the two variables. (For related reading, see:
Negative Correlation
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What is 'Negative Correlation'
Negative correlation is a relationship between two variables in which
one variable increases as the other decreases, and vice versa. In
1.00, a 0.00 indicates no correlation, and a +1.00 indicates a
perfect positive correlation. A perfect negative correlation means the
relationship that exists between two variables is negative 100% of the
time.
BREAKING DOWN 'Negative Correlation'
Negative correlation is used in statistics to measure the amount that a
change in one variable can affect an opposite change in another
variable. Analysts perform a regression analysis to quantify
predictability of the negative relationship between the two variables.
This procedure provides analysts with a calculation of R-squared (R2),
which is the statistical measure of how well one variable predicts the
value of another variable. If the R2 between two separate items is 1, it
means the independent variable accurately predicts the dependent
variable without error. An R2 of 0 implies that the independent variable
cannot predict the dependent variable. An R2 that falls between 0 and
1 measures the extent to which the independent variable predicts the
dependent variable. For example, if R2 is 0.4, this implies that the
independent variable can predict the dependent variable with 40%
accuracy.
For example, the more time a person devotes to purchasing goods at
the mall, the less money he will have in his checking account. The
higher an investor's mutual fund expense ratio, the lower his
investment returns. The more hours a person spends at the office, the
less time he or she has for other activities. All of these variables have a
negative R2.
The Importance of Negative Correlation
Negative correlation is important for any analyst, investor or person
looking to diversify and hedge his bets. If an investor is able to find an
investment class that moves opposite to another set of assets he is
holding, he can invest in both to stabilize his portfolio. Commodities, for
example, are known to move in the opposite direction of the stock
market, on average. If an investor holds a portfolio with a 100%
allocation of public equities, he can sell some of his stock to purchase
precious metals, thus balancing his portfolio from volatility.
However, while negative correlation can be used to reduce the risk of a
portfolio, it can also create a situation where an investor cannot win. If
the two asset classes are perfectly negatively correlated, any gains in
one class are completely offset by the other. Therefore, it is important
to find two different investments that have a small, negative correlation.
This way, if the relationship between stocks and commodities is -0.40,
an investor can reduce, but not completely offset, his losses in times
when stocks are moving downward and still earn a positive return
when stocks increase in value.

Measures
 What are the measures of central tendency?


A measure of central tendency (also referred to
as measures of centre or central location) is a summary
measure that attempts to describe a whole set of data
with a single value that represents the middle or centre
of its distribution.
There are three main measures of central tendency: the
mode, the median and the mean. Each of these measures
describes a different indication of the typical or central value
in the distribution.

What is the mode?
 54, 54, 54, 55, 56, 57, 57, 58, 58, 60, 60

The mode is the most commonly occurring value in a
distribution.
Consider this dataset showing the retirement age of 11
people, in whole years:
54, 54, 54, 55, 56, 57, 57, 58, 58, 60, 60
This table shows a simple frequency distribution of the
retirement age data.
Age Frequency
54 3
55 1
56 1
57 2
58 2 ordered.
60 2
 What is the mean?
The most commonly occurring value is 54, therefore the
mode of this distribution is 54 years.
Advantage of the mode:
The mode has an advantage over the median and the mean
as it can be found for both numerical and categorical (non-
numerical) data.
Limitations of the mode:
The are some limitations to using the mode. In some
distributions, the mode may not reflect the centre of the
distribution very well. When the distribution of retirement age
is ordered from lowest to highest value, it is easy to see that
the centre of the distribution is 57 years, but the mode is
lower, at 54 years.
54, 54, 54, 55, 56, 57, 57, 58, 58, 60, 60
It is also possible for there to be more than one mode for the
same distribution of data, (bi-modal, or multi-modal). The
presence of more than one mode can limit the ability of the
mode in describing the centre or typical value of the
distribution because a single value to describe the centre
cannot be identified.
In some cases, particularly where the data
are continuous, the distribution may have no mode at all (i.e.
if all values are different).
In cases such as these, it may be better to consider using
the median or mean, or group the data in to appropriate
intervals, and find the modal class.
What is the median?
 How does the shape of a distribution influence the
 Measures of Central Tendency?
The median is the middle value in distribution when the
values are arranged in ascending or descending order.
The median divides the distribution in half (there are 50%
of observations on either side of the median value). In a
distribution with an odd number of observations, the median
value is the middle value.
Looking at the retirement age distribution (which has 11
observations), the median is the middle value, which is 57
years:
When the distribution has an even number of observations,
the median value is the mean of the two middle values. In
the following distribution, the two middle values are 56 and
57, therefore the median equals 56.5 years:
52, 54, 54, 54, 55, 56, 57, 57, 58, 58, 60, 60
Advantage of the median:
The median is less affected by outliers and skewed data
than the mean, and is usually the preferred measure of
central tendency when the distribution is not symmetrical.
Limitation of the median:
The median cannot be identified
for categorical nominal data, as it cannot be logically


The mean is the sum of the value of each observation in
a dataset divided by the number of observations. This is
also known as the arithmetic average.
Looking at the retirement age distribution again:
54, 54, 54, 55, 56, 57, 57, 58, 58, 60, 60
The mean is calculated by adding together all the values
(54+54+54+55+56+57+57+58+58+60+60 = 623) and
dividing by the number of observations (11) which equals
56.6 years.
Advantage of the mean:
The mean can be used for
both continuous and discrete numeric data.
Limitations of the mean:
The mean cannot be calculated for categorical data, as the
values cannot be summed.
As the mean includes every value in the distribution the
mean is influenced by outliers and skewed distributions.
What else do I need to know about the mean?
The population mean is indicated by the Greek
symbol µ (pronounced ‘mu’). When the mean is calculated
on a distribution from a sample it is indicated by the
symbol x̅ (pronounced X-bar).


Symmetrical distributions:
When a distribution is symmetrical, the mode, median and
mean are all in the middle of the distribution. The following
graph shows a larger retirement age dataset with a
distribution which is symmetrical. The mode, median and
mean all equal 58 years.

Skewed distributions:
When a distribution is skewed the mode remains the most
commonly occurring value, the median remains the middle
value in the distribution, but the mean is generally ‘pulled’ in
the direction of the tails. In a skewed distribution, the median
is often a preferred measure of central tendency, as the
mean is not usually in the middle of the distribution.
A distribution is said to be positively or right skewed when
the tail on the right side of the distribution is longer than the
left side. In a positively skewed distribution it is common for
the mean to be ‘pulled’ toward the right tail of the distribution.
Although there are exceptions to this rule, generally, most of
the values, including the median value, tend to be less than
the mean value.
The following graph shows a larger retirement age data set
with a distribution which is right skewed. The data has been
grouped into classes, as the variable being measured
(retirement age) is continuous. The mode is 54 years, the
modal class is 54-56 years, the median is 56 years and the
mean is 57.2 years.
A distribution is said to be negatively or left skewed when
the tail on the left side of the distribution is longer than the
right side. In a negatively skewed distribution, it is common
for the mean to be ‘pulled’ toward the left tail of the
distribution. Although there are exceptions to this rule,
generally, most of the values, including the median value,
tend to be greater than the mean value.
The following graph shows a larger retirement age dataset
with a distribution which left skewed. The mode is 65 years,
the modal class is 63-65 years, the median is 63 years and
the mean is 61.8 years.
How do outliers influence the measures of central
tendency?


Outliers are extreme, or atypical data value(s) that are
notably different from the rest of the data.
It is important to detect outliers within a distribution, because
they can alter the results of the data analysis. The mean is
more sensitive to the existence of outliers than the median or
mode.
Consider the initial retirement age dataset again, with one
difference; the last observation of 60 years has been
replaced with a retirement age of 81 years. This value is
much higher than the other values, and could be considered
an outlier. However, it has not changed the middle of the
distribution, and therefore the median value is still 57 years.
54, 54, 54, 55, 56, 57, 57, 58, 58, 60, 81
As the all values are included in the calculation of the mean,
the outlier will influence the mean value.
(54+54+54+55+56+57+57+58+58+60+81 = 644), divided by
11 = 58.5 years
In this distribution the outlier value has increased the mean
value.
Despite the existence of outliers in a distribution, the mean
can still be an appropriate measure of central tendency,
especially if the rest of the data is normally distributed. If the
outlier is confirmed as a valid extreme value, it should not be
removed from the dataset. Several common regression
techniques can help reduce the influence of outliers on the
mean value.
What is a 'Rule Of Thumb'
A rule of thumb is a guideline that provides simplified advice regarding
a particular subject. It is a general principle that gives practical
instructions for accomplishing or approaching a certain task. Typically,
rules of thumb develop as a result of practice and experience rather
than from scientific research or theory. This is why they're regarded as
a heuristic.

BREAKING DOWN 'Rule Of Thumb'

Investors may be familiar with a variety of "financial rules of thumb"

that are intended to help individuals learn, remember and apply
financial guidelines, including those that address methods and
procedures for saving, investing and retirement. Although a rule of
thumb may be appropriate for a wide audience, it may not apply
universally to every individual and unique set of circumstances.

There are a number of financial rules of thumb that provide guidance

for investors, including the following guidelines:

 A home purchase should cost less than an amount equal to

two and a half years of your annual income.
 Always save at least 10% of your take-home income for
retirement.
 Have at least five times your gross salary in life insurance.
 Pay off your highest-interest credit cards first.
 The stock market has a long-term average return of 10%.
 You should have an emergency fund equal to six months'
worth of household expenses.
 Your age represents the percentage of bonds you should
have in your portfolio.
 Your age subtracted from 100 represents the percentage of
stocks you should have in your portfolio.

There are also rules of thumb for determining how much net worth you
will need to retire comfortably at a normal retirement age. Here is the
calculation that Investopedia uses to determine your net worth: If you
are employed and earning income: ((your age) x (annual household
income)) / 10. If you are not earning income or you are a student:
((your age – 27) x (annual household income)) / 10.

Take Rules of Thumb With a Grain of Salt

While rules of thumbs are useful to people as general guidelines, they

may be too oversimplified in many situations, leading to
underestimating or overestimating an individual’s needs. Rules of
thumb do not account for specific circumstances or factors occurring at
a particular time, or that could change over time, which should be
considered for making sound financial decisions. For example, in a
tight job market, an emergency fund amounting to six months of
household expenses does not consider the possibility of extended
unemployment. As another example, buying life insurance based on a
multiple of income does not account for the specific needs of the
surviving family, which include a mortgage, the need for college
funding and an extended survivor income for a non-working spouse.

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