Correlation measures how assets move in relation to each other. Understanding correlation is crucial for building a truly diversified portfolio. Many traders think they are diversified simply because they own multiple positions, but if those positions are highly correlated, they are essentially making the same bet multiple times.
What is Correlation?
Correlation is measured on a scale from -1 to +1:
- +1 (Perfect Positive): Assets move in the same direction, same magnitude
- 0 (No Correlation): Assets move independently of each other
- -1 (Perfect Negative): Assets move in opposite directions
Key Insight: True diversification comes from combining assets with low or negative correlation. Owning five highly correlated assets provides little more protection than owning one.
Correlation Examples
Highly Correlated (0.7 to 1.0)
- Apple (AAPL) and Microsoft (MSFT) - Both big tech
- Exxon (XOM) and Chevron (CVX) - Both oil majors
- JPMorgan (JPM) and Bank of America (BAC) - Both large banks
- SPY and QQQ - Both broad market ETFs
Moderately Correlated (0.3 to 0.7)
- Technology and Healthcare sectors
- US stocks and International stocks
- Large cap and small cap stocks
Low Correlation (0 to 0.3)
- Stocks and Bonds
- Utilities and Technology
- Domestic stocks and Gold
Negative Correlation (-1 to 0)
- Stocks and VIX (volatility index)
- Long positions and short positions
- USD and Gold (often)
Why Correlation Matters for Risk
The Hidden Risk of Correlated Positions
Consider this scenario:
- You have 5 tech stock positions, each risking 2%
- Total individual risk: 10%
- But if tech sector drops, all 5 positions lose simultaneously
- Effective risk: Much closer to 10% than the 2% per position suggests
During the 2022 tech selloff, traders holding "diversified" portfolios of FAANG stocks plus Tesla, NVIDIA, and other tech names experienced this painful lesson.
Correlation Changes During Stress
In market panics, correlations tend to increase. Assets that normally have low correlation suddenly move together as everything sells off. This is when diversification benefits are needed most, but they often disappear.
Building a Low-Correlation Portfolio
Step 1: Diversify Across Sectors
Hold positions in multiple unrelated sectors:
| Sector Group | Examples | Market Behavior |
|---|---|---|
| Growth | Tech, Consumer Discretionary | Thrives in bull markets |
| Defensive | Utilities, Consumer Staples | Stable in downturns |
| Cyclical | Industrials, Materials | Follows economic cycles |
| Financial | Banks, Insurance | Interest rate sensitive |
Step 2: Diversify Across Asset Classes
- Stocks: Core growth exposure
- Bonds: Often negatively correlated to stocks
- Commodities: Inflation hedge, different drivers
- Cash: Zero correlation, always available
Step 3: Diversify Across Strategies
Different trading strategies can be uncorrelated:
- Trend following (performs in trending markets)
- Mean reversion (performs in ranging markets)
- Volatility selling (performs in calm markets)
- Long/short (can profit in any market)
Analyze Your Portfolio Correlation
Pro Trader Dashboard shows correlation between your positions, helping you identify hidden concentration risk.
Practical Correlation Guidelines
Treat Correlated Positions as One
When calculating total portfolio risk, group correlated positions:
Example:
- AAPL position: 2% risk
- MSFT position: 2% risk
- GOOGL position: 2% risk
Rather than viewing these as 6% of uncorrelated risk, treat them as one "Big Tech" position with 6% concentrated risk.
Limit Correlated Group Size
Set limits on how much you allocate to correlated assets:
- Maximum 3-5 positions in the same sector
- Maximum 20-30% of portfolio in any correlated group
- If adding a correlated position, reduce existing ones
Use Hedges Strategically
Negatively correlated positions can offset risk:
- Long stock + Protective put: Limits downside
- Long portfolio + VIX calls: Profits from volatility spikes
- Long tech + Short tech index: Market neutral
Correlation Red Flags
Warning signs that your portfolio lacks true diversification:
- Most positions profit or lose on the same days
- Your P&L closely tracks a single index (like SPY)
- All positions respond similarly to news events
- Drawdowns affect nearly all positions simultaneously
Calculating Correlation
For those who want to calculate correlation:
- Get daily returns for both assets over 30-60 days
- Use the correlation formula or spreadsheet function (CORREL)
- Interpret: Above 0.5 = highly correlated, below 0.3 = low correlation
Many trading platforms and portfolio tools calculate this automatically.
Correlation in Different Market Regimes
Bull Markets
Correlations tend to be lower as different sectors take turns leading. Diversification works well.
Bear Markets
"All correlations go to 1 in a crisis." During panics, almost everything falls together. Only true hedges (like VIX) or cash provide protection.
Recovery Periods
Correlations normalize as markets stabilize. Diversification benefits return.
Summary
Correlation determines whether your positions provide true diversification or just the illusion of it. Highly correlated positions amplify both gains and losses. Build a portfolio with positions across different sectors, asset classes, and trading strategies. Treat correlated positions as a single combined risk. Be especially cautious during market stress when correlations spike. True diversification means your portfolio can survive multiple different scenarios, not just the one where everything goes up together.
Learn more: portfolio risk assessment and portfolio diversification guide.