The fact that asset correlations are higher now means there are not as many places to hide from market volatility. This action in the market could be throwing off exchange traded fund (ETF) diversification strategies quicker than we think.
Correlation is a basic math measure that gauges the extent of two variables and how they move together. So the correlations in the stock market are measuring how different asset classes or stocks are moving to the beat of financial news. If there is not much similarity between the moves of two variables measured, the correlation is zero. However, if one stock moves the same amount or percentage as another, the correlation is one, or 100%, reports Howard Simon on Minyanville.
Correlation is one of the key concepts that portfolio diversification is based upon. The decision to own one ETF or stock versus another depends upon the correlation relationships between the assets chosen and how they will react to market conditions. [Risk-On, Risk-off Trades Drive S&P 500 ETFs]
Rising correlations between asset classes occur when fear hits the markets and investors begin to sell off assets. For instance, the latest news regarding the Eurozone debt crisis and the possibility of a double-dip recession in the U.S. has created a climate of rising correlations between assets that usually move in the opposite direction.
Investors are the drivers of the rising and falling correlations within the market. Once fear hits the market, the mode of all selling and no buying pushes correlations toward one, and devalues diversification. [ETF Correlations Still Elevated in Headline-Driven Market]