Understanding Asset Correlations
Asset correlation measures how different investment categories move in relation to each other, expressed as a coefficient from -1 (perfect inverse movement) to +1 (perfect lockstep). Combining assets with low or negative correlations reduces overall portfolio volatility without proportionally reducing expected returns. This is the mathematical foundation of modern portfolio theory and the primary reason diversification works.
Real-World Correlation Patterns
Over the past two decades, US stocks and US bonds have shown correlations ranging from -0.2 to +0.3. Gold has near-zero correlation with equities over long periods. Developed and emerging market stocks are highly correlated at 0.7-0.8, limiting diversification benefits. REITs correlate 0.5-0.7 with stocks. These are averages; correlations shift significantly with changing economic regimes, interest rate environments, and market sentiment.
The Crisis Correlation Problem
The most dangerous feature of asset correlations is their tendency to spike toward +1 during market crises. In 2008, stocks, corporate bonds, REITs, and commodities all plunged simultaneously as investors fled to cash. Diversification fails precisely when it is needed most. To address this, maintain a meaningful allocation to truly uncorrelated assets like cash and short-term government bonds, and design portfolios based on stress-test correlations rather than calm-market averages.