You think you are diversified because you own ten different stocks. Then a market crash hits, and they all drop together. This is correlation risk - the hidden danger that makes diversification fail precisely when you need it most. Understanding and managing correlation is essential for surviving market turmoil.
What is Correlation?
Correlation measures how two assets move together. It ranges from -1 to +1:
- +1.0: Perfect positive correlation - they always move together
- 0: No correlation - movements are unrelated
- -1.0: Perfect negative correlation - they always move opposite
The problem: During normal markets, correlations are moderate. During crashes, correlations spike toward +1.0. Everything moves together at exactly the wrong time.
Why Correlation Spikes During Stress
In a panic, nuance disappears. Here is what happens:
- Investors sell everything regardless of fundamentals
- Forced liquidation hits all asset classes
- Risk-off behavior affects every risky asset
- Margin calls trigger cascading selling
- Correlations that were 0.3 become 0.9 overnight
Historical Example: March 2020
During the COVID crash:
- Stocks, corporate bonds, commodities, and even gold initially fell together
- Asset class correlations spiked above 0.8
- "Diversified" portfolios lost 30-40% in weeks
- Only cash and Treasury bonds provided protection
Types of Correlation Risk
1. Sector Correlation
Stocks in the same sector move together:
- AAPL, MSFT, GOOGL: Tech sector, high correlation
- XOM, CVX, COP: Energy sector, high correlation
- JPM, BAC, GS: Financial sector, high correlation
Owning five tech stocks is not diversification - it is concentration with different tickers.
2. Market Correlation (Beta)
Most stocks correlate with the overall market:
- High-beta stocks fall more than the market in crashes
- Even "diversified" stock portfolios move with SPY
- Only truly uncorrelated assets provide protection
3. Style Correlation
Similar strategies correlate:
- All momentum stocks reverse together
- All value stocks suffer in growth-favoring markets
- All small caps underperform when risk-off
4. Hidden Correlation
Correlation exists where you do not expect it:
- Airlines and cruise lines (both travel)
- Real estate and banks (both interest-rate sensitive)
- Tech and consumer discretionary (both growth-oriented)
Measuring Correlation
The correlation coefficient can be calculated using historical price data. Most trading platforms provide this, or you can calculate it in a spreadsheet:
Reading Correlation Coefficients
- 0.7 to 1.0: High positive correlation - treat as same position
- 0.4 to 0.7: Moderate correlation - some diversification benefit
- 0.0 to 0.4: Low correlation - good diversification
- -0.4 to 0.0: Slight negative correlation - excellent hedge
- -1.0 to -0.4: Strong negative correlation - effective hedge
Managing Correlation Risk
1. Position Sizing for Correlation
Adjust your position sizes based on correlation:
- Highly correlated positions: Reduce size by 50%
- Treat correlated positions as one larger position
- Calculate portfolio heat accounting for correlation
Correlation-Adjusted Sizing
You normally risk 2% per position. You want to buy AAPL and MSFT (correlation: 0.85).
Instead of 2% each (4% total), treat them as one 4% position split between two stocks.
Risk 2% total: 1% on AAPL, 1% on MSFT.
2. Sector Diversification
Limit exposure to any single sector:
- Maximum 20-25% in any sector
- Spread across at least 4-5 sectors
- Include defensive sectors (utilities, healthcare)
3. Asset Class Diversification
True diversification requires different asset classes:
- Stocks (equity risk)
- Bonds (interest rate exposure)
- Commodities (inflation hedge)
- Real assets (land, gold)
- Cash (true safe haven)
4. Directional Diversification
Mix long and short positions:
- Long positions profit when markets rise
- Short positions profit when markets fall
- Pairs trades can be market-neutral
Hedging Correlation Risk
When you cannot eliminate correlation, hedge it:
Index Puts
Buy SPY puts to protect against market-wide declines. This hedges the correlated portion of your portfolio.
VIX Calls
VIX typically spikes when markets crash. VIX calls provide crisis protection but decay quickly in calm markets.
Tail Risk Hedges
Far out-of-the-money puts cost little but pay big in crashes. Accept that they will often expire worthless.
Correlation in Options Strategies
For options traders, correlation affects strategy selection:
- Selling puts on correlated stocks: All assignments happen together in a crash
- Iron condors during low correlation: Work better when assets move independently
- Calendar spreads: Less affected by correlation since they are on single underlyings
Monitor Your Portfolio Correlation
Pro Trader Dashboard helps you understand your sector exposure and identify correlation risks before they become problems. See your true diversification at a glance.
Building a Correlation-Aware Portfolio
- Identify your exposures: List all positions and their sectors/styles
- Calculate correlations: Use historical data or look up correlation matrices
- Group correlated positions: Treat highly correlated as one position
- Set limits: Maximum exposure per correlation group
- Rebalance regularly: Correlations change over time
- Stress test: Ask "what happens if correlations go to 1.0?"
The Correlation Paradox
Here is the frustrating truth: correlations are lowest when you need diversification least (calm markets) and highest when you need it most (crisis). This means you must:
- Plan for correlation spikes before they happen
- Accept that "diversified" portfolios will still fall in crashes
- Hold some truly uncorrelated assets (cash, Treasury bonds)
- Consider explicit hedges for tail events
Summary
Correlation risk is the hidden danger in seemingly diversified portfolios. During market stress, correlations spike and everything moves together. Manage this by measuring correlations, sizing positions appropriately, diversifying across truly different asset classes, and considering hedges for extreme events. The goal is not to eliminate correlation risk (impossible) but to understand and prepare for it.
Learn more about protecting your portfolio with tail risk management or understand Value at Risk (VaR) for measuring portfolio risk.