Correlation

How closely two investments move together

Understanding correlation for better portfolio diversification and risk management
Modified

September 7, 2025

Category: General Finance
Difficulty: Beginner

Definition

A number from -1 to +1 that shows how closely two investments move together. Higher numbers mean they move more similarly.

How Correlation Works

The Correlation Scale

+1.0 (Perfect Match) - When one goes up 10%, the other goes up 10% - No diversification benefit - Very rare in real life

+0.5 (Moderate Match) - Often move in the same direction, but not always - Some diversification benefit - Common between related investments

0 (No Pattern) - No predictable relationship - Great for diversification - Example: Stocks and bonds often near zero

-0.5 (Opposite Pattern) - Often move in opposite directions - Excellent diversification - Natural hedge against losses

-1.0 (Perfect Opposite) - When one goes up 10%, the other goes down 10% - Can eliminate all risk - Almost never happens

Why Correlation Matters

For Risk Reduction - Low correlation = better diversification - High correlation = little protection - Mix uncorrelated investments to reduce volatility

Common Correlations - U.S. large-cap stocks: 0.7 to 0.9 (high) - Stocks vs. bonds: 0.0 to 0.3 (low) - Stocks vs. gold: -0.1 to 0.2 (low) - Same sector stocks: 0.6 to 0.8 (high)

What Changes Correlation

Market Conditions

  • Crisis periods: Everything falls together (correlation goes to +1)
  • Normal times: More varied patterns
  • Bull markets: Lower correlations
  • Bear markets: Higher correlations

Time Factors

  • Correlations change over time
  • Long-term patterns differ from short-term
  • Recent data may not predict future relationships

Practical Applications

Building Portfolios

  • Combine assets with low correlation
  • Don’t just look at returns—check correlation
  • Geographic diversification helps lower correlation
  • Different asset classes (stocks, bonds, real estate) help

Simple Rules

  • If correlation is above 0.7, limited diversification benefit
  • Mix of stocks and bonds typically provides good diversification
  • International investments can lower overall correlation
  • Don’t own too many similar investments

Limitations

  • Past correlation doesn’t guarantee future correlation
  • Crisis periods break normal correlation patterns
  • Correlations between most assets increase during market stress

External Resources