A Primer On Correlation

Correlation refers to how closely one asset moves in conjunction with another asset. It can range from -1 to 1. 1 would mean two things move in perfect lock-step. -1 would mean they move in the exact opposite direction (one asset goes up, the other goes down the same amount). In reality it’s never that exact but the direction and magnitude do matter.

Here’s a quick look at how major asset classes tend to be correlated to one another.

(Couresy of portfoliovisualizer)

Starting from the top, the total stock market has extremely high correlation with the mid-cap section of the market and the small cap section (0.98 and 0.95 respectively). This should be intuitive as the total stock market is comprised of those companies held in the other two indices.

On the flip side, there is negative correlation between the stock indexes and bonds or treasuries (-0.30 to SHY, -0.31 to BND, -0.47 to TLT). This means when stocks move up, bonds and treasuries tend to move down slightly.

There is higher correlation with international stocks, ranging from 0.83 to 0.89 in the graphic above. Real Estate is a little lower at 0.73.

Finally, gold tends to have no correlation with stocks and very low positive correlation with bonds and treasuries.

Diversification works when adding assets that do not share the same correlation. As an example, having 100% of a portfolio in real estate will not offer much diversification or protection against a decline in real estate.