Glossary / Markets

Correlation

Correlation measures how two assets move relative to each other on a scale from minus one to plus one, and diversification only works to the extent that the correlation between holdings is below one.

It is not stable. Assets that behave independently in calm markets frequently move together in a crisis, which is when the diversification was supposed to help.

A portfolio of several holdings that all need the same economic conditions is concentrated regardless of how many lines it has.

Where people get it wrong

Treating a historical correlation as a property of the asset. It is a description of a past period, and the periods that matter most are the ones where it changes.

The framework behind it All Weather and the four boxes sets out the rule, the arithmetic and where it breaks.

Read the framework

Related terms

Home bias Home bias is the tendency to hold far more of one's own country's assets than its share of the world market justifies, driven by familiarity rather than by analysis. Rebalancing Rebalancing is selling assets that have grown beyond their target weight and buying those that have fallen below it, restoring a portfolio to its intended allocation. Real yield Real yield is the return on a bond after inflation, observable directly in the market as the yield on an inflation protected government bond, and it is the hurdle every other asset has to beat to be worth owning.

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