Correlation: why diversification sometimes stops working

Diversification rests on assets behaving differently. The measure of that difference is correlation.

How it works

Assets that move out of step damp each other's swings.

{{figure:correlation|caption=A portfolio of assets moving out of phase fluctuates less than either of them separately}}

The main caveat

Correlations are not constant. In calm times assets diverge; in a crisis they converge: everything is sold at once because money is needed.

How to account for it

Do not treat historical correlation as a constant. Check what happens if it rises to one — that is, if everything falls together.

Separate sources of risk rather than names of assets: two securities from different sectors that depend on the same factor create a false sense of variety — Sectors of the Russian market: what it is made of.

What genuinely diverges

Assets with fundamentally different sources of income: equities live on company profits, bonds on interest payments, gold has no cash flow at all.

That is exactly why allocating across classes is more effective than allocating within one — Asset allocation: the decision that shapes everything else.

And a separate class

Infrastructure risk obeys no correlation at all: it materialises simultaneously for everything recorded through the same chain — Restrictions and infrastructure risk: how it differs from market risk.

Related: Diversification: what it gives and what it does not.