Asset correlation

Correlation describes how much the returns of two assets move in the same direction. The most common measure is the Pearson correlation coefficient, which ranges from −1 to 1.

• Correlation of 1: the assets move perfectly together, e.g. two ETFs on the same index.
• Correlation close to 0: one asset’s moves say little about the other’s.
• Correlation of −1: the assets move perfectly in opposite directions.

Why correlation matters

Combining assets with low correlation lowers the volatility of the whole portfolio without giving up expected return. Two companies from the same industry are usually highly correlated, so they add little diversification. Stocks and bonds, gold, or assets from different regions often have a much lower correlation.

Things to keep in mind

• Correlation is calculated from returns, not price levels. Two assets that have both risen for years can still have very different daily moves.
• Correlation is not constant. During market panics, correlations between stocks usually rise and diversification works less well than historical data suggests.
• Correlation depends on the currency you measure returns in. For a Polish investor, the zloty exchange rate can change the relationship between foreign assets.
• Correlation does not imply causation and says nothing about the size of moves, only their direction.