Question

During periods of extreme market stress, what happens to the diversification benefits of a portfolio if the correlation between all asset classes shifts toward positive one?

Accepted Answer

Diversification is an investment strategy of spreading money across different types of assets, such as stocks, bonds, and commodities, to reduce risk. Under normal conditions, these assets often have low or negative correlations, meaning they do not all move in the same direction at the same time. Correlation is a statistical measure ranging from negative one to positive one that describes how two assets move in relation to each other. When the correlation between all asset classes shifts toward positive one during extreme market stress, it means that every asset in the portfolio begins to move in the same direction, which is typically downward. Consequently, the diversification benefits vanish because the portfolio no longer contains assets that offset the losses of others. For example, if a portfolio holds both stocks and government bonds and their correlation shifts to positive one, a sell-off in the stock market will be accompanied by a simultaneous drop in bond prices, causing the total value of the portfolio to fall significantly. At this point, the portfolio acts like a single asset, leaving the investor fully exposed to the market crash without the protection that diversification usually provides.

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During periods of extreme market stress, what happens to the diversification benefits of a portfolio if the correlation between all asset classes shifts toward positive one?