What is Correlation?
Correlation measures the degree to which two assets move in relation to each other, expressed as a coefficient between -1 and +1. A correlation of +1 means two assets move in perfect lockstep. A correlation of -1 means they move in exactly opposite directions. A correlation of 0 means their movements are completely independent. For portfolio construction, combining assets with low or negative correlations reduces overall portfolio risk.
Correlation in Portfolio Construction
US stocks and bonds have historically had a low or slightly negative correlation, making them natural diversification partners. International stocks have moderate correlation with domestic stocks (typically 0.6-0.8), providing some diversification benefit. Gold has near-zero correlation with stocks over long periods, making it a popular portfolio diversifier. REITs have moderate correlation with both stocks and bonds, offering partial diversification.
Key Considerations
Correlations are not stable over time. During market crises, correlations between risky assets tend to spike toward +1 as investors sell everything simultaneously. This means diversification provides less protection precisely when you need it most. Building portfolios with truly uncorrelated assets, not just historically low-correlation assets, provides more robust protection during extreme market events.