Correlation
A statistical measure ranging from -1 to +1 that describes how two investments move relative to each other. Low or negative correlation between assets improves diversification.
Correlation is the mathematical backbone of diversification. When two assets have a correlation of +1, they move perfectly in tandem; at −1, they move in exactly opposite directions; and at 0, their movements are unrelated.
Why Correlation Matters for Portfolios
By combining assets with low or negative correlations, you can reduce overall portfolio volatility without necessarily sacrificing return. This is the fundamental insight behind Modern Portfolio Theory. For example, stocks and high-quality bonds have historically exhibited low correlation, which is why the classic 60/40 portfolio has been a staple asset allocation strategy.
However, correlations are not static. During market crises, correlations between risky assets tend to spike toward +1 as investors sell indiscriminately. This phenomenon, known as correlation breakdown, means that diversification benefits can diminish exactly when they are needed most. Regularly reviewing correlation data is an important part of portfolio rebalancing.