Definition
Correlation measures the direction and strength of the linear relationship between two assets' returns. +1.0 means perfect co-movement, -1.0 means perfect inverse movement, 0 means no linear relationship. Lower correlations between portfolio holdings enhance diversification benefits. Importantly, correlations are not constant—they tend to increase during market crises when diversification is needed most.
functions Formula
ρ = Cov(X,Y) / (σx × σy)
lightbulb Example
US stocks and bonds have historical correlation of ~0.0 to -0.3, providing good diversification. US and international stocks correlate at ~0.7-0.8—helpful but limited diversification. During 2008, most correlations spiked toward 1.0.
verified_user Key Points
- Ranges from -1.0 (inverse) to +1.0 (same direction)
- Lower correlation = better diversification
- Correlations increase during market crises
- Not constant—must be monitored over time