Correlation
How closely two assets move together, from +1 (in lockstep) to −1 (opposite). When it is low, it is what makes diversification work.
Correlation measures the degree to which two assets move in the same direction. Near +1 they rise and fall together; near −1 they move oppositely; near 0 they move independently. It is the mathematics behind diversification.
Combining assets with low or negative correlation smooths a portfolio's ride, because their ups and downs partly offset. The catch: correlations are not fixed. In sharp sell-offs many assets fall together, exactly when diversification is needed most.
Related terms
- DiversificationSpreading capital across assets that behave differently, so weakness in one is offset by others. It reduces avoidable risk but does not remove market-wide risk.
- Asset classA broad category of investments that behaves distinctly (equities, bonds, gold, commodities): the building blocks of a diversified, tactically allocated portfolio.
- VolatilityHow much an asset's price fluctuates over time. High volatility means larger swings. It measures turbulence, not direction, and it is not the same thing as risk.
Read it in context
- GoldGold has no issuer, no contract and no internal cash flow: nothing about it pays you for holding it. Its return comes entirely from the change in its price, which makes it a different kind of asset from a share or a bond rather than a defective version of either.
- Real versus apparent diversificationCounting your funds answers one question about diversification and is silent on another. It tells you something about how exposed you are to any single company failing; it tells you nothing about what your holdings have in common. That is what decides whether they fall together.