When constructing an investment portfolio, investors want their portfolios to be diversified. The idea is simple: do not put all your eggs in one basket. However, it is not that simple. One critical but often overlooked factor is correlation—the way different investments move in relation to each other. Understanding correlations can help investors build more resilient portfolios that weather markets ups and downs more effectively.
What Is Correlation in Investing?
Correlation measures how two investments move relative to each other. It is expressed as a value between -1 and +1. Two investments are perfectly correlated (+1) when they move in the same direction at the same time. For example, if one stock goes up by 10%, the other one goes up by exactly 10%. This is extremely rare in real-word markets.
On the other hand, when there is a perfect negative correlation (-1), the two assets move in opposite directions. If one rises by 5%, the other falls by 5%, which is also rare. When the correlation between two assets is zero, their movements are unrelated. In other words, there is no predictable relationship between them.
In an ideal diversified portfolio, you want assets that are not highly correlated. This ensures that when one part of your portfolio experiences volatility, other parts help stabilize overall performance.
The Illusion of Diversification
Many investors assume they are diversified simply because they own multiple stocks or funds. However, if those investments are highly correlated, they tend to move together during market downturns.
For instance, owning too many stocks within the same sector can inadvertently increase risk rather than reduce it. Stocks within the same sector tend to be highly correlated, meaning they are likely to move in the same direction during market fluctuations. For example, if an investor holds multiple technology stocks and the sector experiences a downturn due to regulatory changes or declining demand, all those stocks may suffer losses simultaneously.
Just as sector concentration increases risk, so does concentrating investments within a single country. Stocks from the same country tend to have a high correlation because they are influenced by shared economic conditions, government policies, currency fluctuations, and interest rate changes. For example, Canadian stocks, even across different sectors, tend to be influenced by commodity prices, the strength of the Canadian dollar, and domestic economic trends. In contrast, holding international equities can provide diversification benefits, as different economies experience growth cycles at different times. Geographic diversification helps mitigate country-specific risks, such as political instability or economic downturns, that could negatively impact an investor’s entire portfolio if all holdings are in one country.
Why Correlation Matters for Investors
A well-diversified portfolio aims to reduce overall risk without sacrificing returns. Investing in assets with lower or negative correlation can help achieve this by smoothing portfolio fluctuations. If two investments have a low or negative correlation, losses in one may be offset by gains in another, reducing overall volatility. Diversifying across uncorrelated assets can lead to steadier long-term returns, avoiding extreme ups and downs. Assets such as government bonds or gold often have low or negative correlation with equities, making them useful for preserving value during stock market downturns.
Achieving True Diversification
- Having stocks from multiple sectors in the portfolio: Including stocks from various sectors helps build a more robust portfolio.
Source: Morningstar as of 31 Jan 2025
The chart above shows the 10-year correlation matrix for a few selected sectors. For example, the correlation between the Communication Services sector (1) and Health Care Services sector (5) is 0.13. This very low correlation coefficient signifies a weak relationship between the two sectors, which is exactly what we want in a well-diversified portfolio. To mitigate risk, investors should consider spreading their equity exposure across different sectors to ensure that a downturn in one sector does not disproportionately impact their portfolio.
- Domestic vs. International Stocks: Investing in both domestic and international markets can reduce country-specific risks, as different economies perform differently over time. Geographic diversification helps mitigate country-specific risks, such as political instability or economic downturns, that could negatively impact an investor’s entire portfolio if all holdings are in one country. While domestic stocks may benefit from local economic growth, international equities provide exposure to regions that may be experiencing stronger expansion. For example, during periods when North American markets struggle, emerging markets or European equities may offer better returns. Additionally, currency fluctuations can create further diversification benefits, as international stocks are influenced by different monetary policies and exchange rate movements.
- Equities and Bonds: Historically, stocks and government bonds have had a low or negative correlation, making bonds a traditional diversifier in equity-heavy portfolios. When equity markets decline, investors often seek the safety of bonds, driving bond prices higher. This inverse relationship has helped stabilize portfolios during market downturns. However, the correlation between stocks and bonds can fluctuate over time, especially in environments with rising interest rates or inflation concerns. Despite this variability, bonds remain an essential tool for managing risk and reducing volatility in equity-dominated portfolios.
How Wealth Managers Use Correlation to Build Stronger Portfolios
While historical correlations provide valuable insights, they are not static. During financial crises, assets that usually have low correlation, such as stocks and bonds, can suddenly move in the same direction. Investors should regularly review their portfolios and adjust diversification strategies as market conditions evolve.
Professional wealth managers analyze correlations when constructing client portfolios to ensure they are not overly exposed to a single market risk. By selecting investments with different correlation characteristics, they aim to enhance long-term performance while managing downside risk.
Conclusion
Understanding correlation is an essential part of smart investing. By building a portfolio with assets that do not all move in the same direction, investors can reduce risk, achieve more stable returns, and improve their overall financial outcomes. If you have questions about how correlation impacts your investments, the Daley Wealth Management team can help you navigate the complexities of portfolio diversification.
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