What is Correlation? (Plain English Definition)
Correlation measures how closely two investments move in relation to each other, ranging from +1 (move together perfectly) to -1 (move in opposite directions).
Last updated: April 2026
Definition: Correlation measures how closely two investments move in relation to each other, ranging from +1 (move together perfectly) to -1 (move in opposite directions).
Correlation Explained Simply
Correlation is a statistical measure that shows how two investments move relative to each other. It ranges from +1.0 to -1.0. A correlation of +1.0 means two assets move perfectly in sync -- when one goes up 5%, the other goes up 5% too. A correlation of -1.0 means they move in exactly opposite directions. A correlation of 0 means there is no predictable relationship between their movements.
In practice, most stock ETFs are positively correlated with each other. U.S. large-cap and small-cap stocks might have a correlation of 0.85, meaning they usually move in the same direction but not identically. U.S. stocks and international stocks might correlate at 0.70. Stocks and bonds typically have a low or slightly negative correlation, perhaps 0.1 to -0.3, which is why they pair well in a diversified portfolio.
Correlation is central to modern portfolio theory and the concept of diversification. By combining assets with low or negative correlations, you can reduce your portfolio's overall volatility without necessarily sacrificing returns. The idea is that when one asset is declining, another with low correlation may hold steady or rise, smoothing out your portfolio's ride.
Correlation Example
Your portfolio has two ETFs: a U.S. stock ETF and a U.S. bond ETF with a correlation of -0.2. In a month when stocks drop 8%, bonds might rise 3% instead of falling. If your portfolio is 70% stocks and 30% bonds, the overall decline is only about 4.7% instead of 8%. This smoothing effect is the practical benefit of holding assets with low correlation.
Why Correlation Matters for ETF Investors
Correlation is the reason diversification works. If all your investments were perfectly correlated, adding more ETFs to your portfolio would not reduce risk at all. The power of diversification comes from combining assets that do not always move together. For ETF investors building a portfolio, understanding correlation helps you choose ETFs that genuinely diversify each other. Owning five different U.S. large-cap ETFs provides almost no diversification benefit since they are nearly perfectly correlated. But combining a U.S. stock ETF, an international stock ETF, a bond ETF, and a real estate ETF provides meaningful diversification because these asset classes have lower correlations with each other.
Correlation vs Diversification
| Correlation | Diversification |
|---|---|
| Correlation measures how closely two investments move in relation to each other, ranging from +1 (move together perfectly) to -1 (move in opposite directions). | See full definition of Diversification |
While correlation and diversification are related concepts, they serve different purposes when picking and evaluating ETFs. Understanding both terms helps you make more informed decisions about which funds to include in your portfolio and how to evaluate their performance.
Related Terms
Deepen your understanding of ETF investing by exploring these related concepts:
Diversification
Diversification is the strategy of spreading investments across different assets to reduce risk, based on the principle of not putting all your eggs in one basket.
Modern Portfolio Theory (MPT)
Modern portfolio theory is a framework for constructing portfolios that maximize expected return for a given level of risk through diversification.
Asset Allocation
Asset allocation is the strategy of dividing your investment portfolio among different asset categories like stocks, bonds, and cash.
Beta
Beta measures how much an investment's price tends to move relative to the overall market, indicating its volatility compared to a benchmark.
Volatility
Volatility measures how much and how quickly an investment's price changes, with higher volatility meaning larger and more frequent price swings.
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