Correlation

Correlation measures how two assets move together, ranging from -1 (perfectly opposite) to +1 (perfectly together). A correlation of 0 means the assets move independently. It's the foundation of diversification.

Correlation normalizes the covariance between two assets by their individual volatilities, producing a standardized measure from -1 to +1.

• -1 to -0.5Strong negative - assets move in opposite directions
• -0.5 to 0Weak negative - some diversification benefit
• 0Uncorrelated - independent movements
• 0 to 0.5Weak positive - limited diversification benefit
• 0.5 to 1Strong positive - assets tend to move together

US stocks and bonds historically have correlation around 0.2. During market stress, this often becomes negative (bonds rise when stocks fall), providing diversification exactly when you need it most.

Correlation is the key to diversification. Adding assets with low or negative correlation to your portfolio can reduce overall risk without sacrificing expected returns—the free lunch of investing.

• Assuming correlations are stable (they change, especially during crises)
• Only looking at historical correlation without understanding drivers
• Ignoring that correlations tend to increase during market stress