Correlation Between Assets and the Diversification Effect
Why you should hold stocks and bonds together, and why adding gold increases stability—it can all be explained by the concept of correlation.
What Is Correlation
Correlation expresses how similarly two assets move, as a number between -1 and +1.
+1: perfect positive correlation. When one rises, the other rises identically. No diversification effect. 0: uncorrelated. The two assets move independently. Moderate diversification effect. -1: perfect negative correlation. When one rises, the other falls. Theoretically a perfect hedge.
Illustrative historical correlations (subject to change): U.S. stocks – U.S. long-term bonds: about -0.1 to -0.3 (low negative correlation) U.S. stocks – gold: about 0.0 to 0.1 (nearly uncorrelated) U.S. stocks – emerging market stocks: about +0.7 to +0.8 (high positive correlation)
Correlation changes greatly over time. In particular, during financial crises many assets' correlations temporarily converge toward 1.
Correlation and Portfolio Volatility
According to Markowitz's Modern Portfolio Theory, combining assets with low correlation can create a portfolio with lower volatility than the individual assets.
Example: combining stocks (20% volatility) and bonds (7% volatility) 50:50. If the correlation is -0.2, the portfolio volatility ends up lower than the simple average (13.5%).
This is the diversification effect known as "the only free lunch." You can reduce risk without giving up much return.
The Trap of Correlation: Convergence in a Crisis
There is a major weakness in diversification: when the market panics, correlations tend to converge toward 1.
2008 financial crisis: stocks, REITs, corporate bonds, and emerging market bonds all crashed together. Assets that normally moved differently fell together.
True diversification benefits tend to disappear in a crisis. For this reason, government bonds (especially U.S. Treasuries) are recognized as a rare asset that rises even in a true crisis. Gold, by contrast, is inconsistent in a crisis.
Frequently Asked Questions
Q. Does adding bitcoin to a portfolio provide diversification?
In the 2010s, bitcoin had low correlation with traditional assets. But as institutional participation grew in the 2020s, its correlation with stocks has tended to rise. In 2022, stocks and bitcoin plunged together. Bitcoin's diversification benefit varies greatly by period, and its volatility is very high.
Q. How do you calculate correlation?
You use the Pearson correlation coefficient. You collect daily or monthly return data for the two assets and divide the covariance by the product of each asset's standard deviation. In Excel, you can compute it with the CORREL() function. Because correlation differs across periods, it is important to check it over several periods.
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📋 Results are based on historical data; past returns do not guarantee future returns.
📋 This service is provided for educational purposes to help you understand investing, not as investment advice.