Correlation (ρ) measures the degree to which two securities' returns move together. It ranges from −1.0 to +1.0.
Interpretation:
| Correlation | Meaning | |---|---| | +1.0 | Perfect positive correlation — move identically | | +0.5 | Moderate positive correlation — tend to move together | | 0 | No correlation — moves are independent | | −0.5 | Moderate negative correlation — tend to move opposite | | −1.0 | Perfect negative correlation — move in exactly opposite directions |
Why correlation matters for diversification: - Adding assets with low or negative correlation reduces portfolio risk without necessarily reducing expected return. - Two assets with +1.0 correlation provide no diversification benefit. - Two assets with −1.0 correlation can theoretically eliminate all risk (the perfect hedge).
Modern Portfolio Theory (MPT): Correlation is central to portfolio construction. The efficient frontier identifies portfolios with the highest expected return for a given level of risk — achieved by combining assets with low correlations.
Correlation vs. causation: Two assets can be correlated without one causing the other's movements (e.g., both driven by a common macroeconomic factor).
Correlation tends to rise in crises: During market crashes, correlations across asset classes tend to increase (assets move together), reducing diversification benefits precisely when they're most needed.
> Exam tip: Correlation = diversification benefit. Perfect negative correlation = maximum diversification. Adding a low-correlation asset to a portfolio reduces overall volatility. The correlation formula is in the CFP® and CFA curriculum; on Series 65/66 the concept is more important than the calculation.