Definition
Correlation risk materializes when asset correlations increase during crises, precisely when diversification is needed most. In normal markets, stocks and bonds may have -0.2 correlation, but during a liquidity crisis, both can sell off simultaneously (correlation approaches +1.0). This "correlation breakdown" can devastate portfolios designed for normal correlation regimes.
lightbulb Example
In 2022, both stocks and bonds fell sharply as the Fed aggressively raised rates. The traditional negative stock-bond correlation that protected 60/40 portfolios for decades reversed, causing the worst year for balanced portfolios in decades.
verified_user Key Points
- Correlations increase during crises
- Undermines diversification when most needed
- 2022 showed stock-bond correlation can reverse
- Dynamic hedging and alternatives can help