Correlation

Correlation is the statistical measure of how two assets move together, scored between +1 and -1. A correlation of +1 means the assets move identically, 0 means no relationship, and -1 means they move opposite. Diversification works on the number: combining assets with low or negative correlations produces a portfolio less volatile than any of its parts, because the falls land at different times and different sizes.

The catch is that correlations are not constant - they rise in panics. In March 2020, correlations across asset classes spiked toward 1 as everything sold together, and the diversification a portfolio counted on evaporated for exactly the weeks it was needed. The Australian manifestation is the index itself: ASX-listed stocks correlate heavily with each other because the index is concentrated in banks and miners, and international shares add a different driver - different cycles, different currency, different central bank.

The portfolio arithmetic is the first mechanism. Two assets each with 15 percent volatility and a 0.3 correlation combine into a portfolio with roughly 12.1 percent volatility - lower than either asset alone, which is the diversification working. Push the correlation to 0.9 and the same pair combines into roughly 14.6 percent volatility - the diversification evaporated, and the portfolio behaves like a single asset with a bad day built in. The correlation calculator runs any pair.

The panic is the second mechanism, and the structural one. Correlations between risky assets rise in sell-offs because the selling is driven by the same forces: deleveraging, margin calls and redemptions. In March 2020 the correlation between shares and almost everything else spiked toward 1 - the exception being government bonds, which usually hold the line but wobbled even there in the worst week. A portfolio built on 2019's correlations owned 2020's correlations, which is the trap: the number is measured on calm data and needed in the panic.

The index is the third mechanism, and the Australian one. ASX stocks correlate with each other at high levels because the market is concentrated - banks and miners dominate the capitalisation, and a resources slump takes most of the register with it. Adding international shares introduces different drivers - different cycles, currency exposure, a different central bank - and lowers the correlation of the whole portfolio. The diversification entry covers the split, and the portfolio rebalancing entry covers keeping it honest.

For an Australian reader, correlation is the number behind the advice to diversify beyond the ASX. A portfolio of ten ASX stocks is less diversified than it looks, because the stocks correlate with each other at high levels through the banks and miners that dominate the index. International shares, bonds and cash run on different drivers, and the correlations between them are lower in calm markets - which is the diversification that holds. The portfolio diversification calculator runs the arithmetic on any mix.

A colleague named Brent (yes, that Brent) held ten ASX shares across five sectors and called it diversified. The March 2020 panic repriced all ten together - the correlations he had counted on spiked toward 1, and the portfolio fell like a single stock. The highest-leverage thing most Australians can do is size the diversification on the correlations that hold in panics, not the ones measured in calm years - and that usually means the whole market, some of it international.