The correlation coefficient measures the strength and direction of the relationship between two assets' returns. A value of +1 means they move in lockstep; 0 means no relationship; −1 means they move exactly opposite. Diversification only reduces portfolio risk when correlation between holdings is meaningfully below +1 — adding an asset that moves identically to what you already own adds risk without adding any offsetting benefit.
The formula
Covariance of Assets A & B(Std. Dev. A) × (Std. Dev. B)
= Correlation Coefficient
Why it matters
- —It's the mathematical basis for Modern Portfolio Theory — combining low- or negatively-correlated assets reduces overall portfolio volatility without necessarily reducing expected return.
- —Correlations are not fixed — in severe market crises, correlations across equities and even some asset classes often converge toward +1, which is exactly when diversification is needed most and works least.
- —Owning many stocks in the same sector is not real diversification if they're all highly correlated to the same growth and rate inputs.
How to read it
| +0.7 to +1.0 | Highly correlated — limited diversification benefit |
| −0.3 to +0.3 | Low or no correlation — meaningful diversification benefit |
| −1.0 to −0.3 | Negatively correlated — strong diversification, can offset losses |