Building a portfolio
Correlation
A measure from −1 to +1 of how closely two investments move together.
How it works
At +1 two holdings move in lockstep; at 0 there is no relationship; at −1 they move exactly opposite. Diversification works to the extent that correlations are below 1.
Correlation describes co-movement, not magnitude. Two assets can be perfectly correlated while one moves five times as far, so correlation alone does not tell you how much risk a pair adds.
Where it misleads people
Correlations are unstable and get worse when you need them. Assets that averaged 0.3 correlation for a decade can move to 0.9 in a crisis, because in a panic people sell what they can rather than what they should.
Related terms
- DiversificationSpreading money across things that do not move together, so no single failure can decide your outcome.
- BetaHow much an investment tends to move when the market moves, with 1.0 meaning it moves in line.
- CovarianceHow two investments move together, measured in units that also reflect how much each one moves.
- Systematic riskRisk that affects the whole market and cannot be removed by holding more things.
Mentioned in
More in Building a portfolio
- Core and satellite
- Drift
- Effective number of holdings
- Asset allocation
- Efficient frontier
- Tactical asset allocation
- Fund overlap
- Strategic asset allocation
All 20 Building a portfolio terms · The full glossary, 433 terms
Educational reference only. Nothing here is investment advice or a recommendation to buy or sell anything, and tax treatment depends on your own circumstances and the country you are in.