Correlation breakdown

The tendency for historical relationships between assets to stop holding under stress, as correlations between risky assets converge towards one in a severe decline.

Example

An asset held specifically for its low correlation to equities falls alongside them in a crisis, because investors sell what they can rather than what they would prefer to.

Important

Diversification is weakest precisely when it is being relied on. Never build a portfolio whose survival depends on a historical correlation holding at the worst moment.

Related terms

• Correlation — A measure from +1 to -1 of how closely two assets have moved together over a chosen period. +1 is lockstep, 0 is no relationship, -1 is exactly opposite.
• Systematic risk — Risk shared by everything in a market - the economy, interest rates, inflation, currency, broad sentiment. Also called market risk.
• Forced selling — Selling because you have to rather than because you chose to - triggered by a lender, a redemption request, or an unrelated need for cash.

Lessons that explain it

• This belongs in the money you could genuinely lose, sized small, and held for reasons beyond the return — The apparent low correlation with financial markets is partly real and partly an artefact of how these assets are valued - and once round-trip costs and total-loss risk are honestly priced in, this asset class fits only as a small, patient allocation of money whose absence would not change anyone's plans. (10 min)
• The job bonds do: a date, a sum, and a different response to the same shock — Only fixed income lets you name the amount and the day in advance. The diversification argument is the one usually made for it, and it is the one that has failed. (8 min)
• Correlation: what actually moves together — Diversification is only worth what the independence behind it is worth, and correlation is how that independence is measured - including the fact that it changes exactly when you need it not to. (12 min)
• Defaults cluster, exits close, and interest is often taxed as income — The key risks are defaults rising together in a downturn, being unable to exit, and intermediary failure. Costs include layered fees, and interest is frequently taxed less favourably than gains. (12 min)

All 578 terms in the Investing glossary