Glossary · UK
What is Correlation (Investing)?
A measure of how closely the returns of two investments move together, used to build a diversified portfolio of assets that do not all rise and fall in tandem.
Full Definition
In investing, correlation measures the extent to which the returns of two different assets or asset classes move together over time, expressed as a figure between -1 and +1: a correlation of +1 means two investments move perfectly in step, -1 means they move perfectly in opposite directions, and 0 means their movements are unrelated. Correlation matters most for diversification: combining assets that are not highly positively correlated (for example, shares and government bonds have historically shown low or even negative correlation at times) means that when one part of a portfolio falls in value, another part is less likely to fall at the same time, which can smooth overall portfolio returns and reduce volatility compared with holding assets that all tend to move together. UK investors building a diversified portfolio across asset allocation between shares, bonds, property and cash are, in effect, using correlation as a key input, even if only implicitly through following general diversification guidance rather than calculating correlation figures directly, since the benefit of adding more holdings to a portfolio depends heavily on how closely those holdings' returns are correlated with what is already held, not simply on how many different funds or shares are included. A key practical limitation is that correlations between assets are not fixed and can shift over time, and history has shown that in a severe market crisis, correlations between normally weakly linked assets can rise sharply as investors sell many different types of assets simultaneously, somewhat reducing the diversification benefit precisely when it is most needed.