Correlation

The correlation coefficient describes how consistently two sets of returns move in step. A value of +1 means they always move in the same direction, in proportion; −1 means they always move in opposite directions; 0 means there is no linear relationship between them. It is usually calculated from past daily, weekly or monthly returns. Correlation says nothing about the size of the moves: two assets can be highly correlated while one moves far more than the other, which is what beta captures.

Correlation is the engine of diversification. Combining assets with a correlation below +1 produces a portfolio whose volatility is lower than the weighted average of its parts, and the lower the correlation, the bigger the benefit. The catch is that correlations are not fixed. Estimates from calm periods can mislead, because many risky assets tend to become more correlated in a crisis, just when the benefit is needed most. The relationship between shares and government bonds, for example, has switched between positive and negative over different decades.