Unit 2 · Level 2 · Diversification
When everything falls together
Correlation measures how much two assets move together: +1 is lockstep, 0 is unrelated, −1 is mirror image. The lunch has fine print, though. In 2008, stocks, property, commodities, and corporate bonds all fell together; only high-quality government bonds held up. Traders have a grim saying: 'in a crisis, correlations go to one.' Diversification helps most in normal times and least at the exact moment you want it most.
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What you get asked
Two assets have a correlation close to +1. What does that mean?
Correlation runs from −1 (mirror opposites) through 0 (unrelated) to +1 (lockstep). Owning two lockstep assets is diversification theatre: one bet, two tickers.
An investor held 50 different stocks in 2008 and still lost about half. Why didn't the variety save him?
Fifty stocks diversify away company-specific risk, but in 2008 it was the entire market falling. More stocks can't dilute a risk that every stock shares.
In a panic, correlations between risky assets tend to lurch toward ___.
Assets that looked independent in calm markets suddenly fall as one. Build your plan for crisis correlations, not sunny-day ones.
Put in order how a crisis drags 'unrelated' assets down together
Panics are about forced sellers, not fundamentals. When everyone needs cash at once, even good assets get thrown overboard. That's why correlations spike exactly in crashes.
What actually cushioned diversified portfolios in 2008?
Safe government bonds were the rare asset that zigged while everything else zagged. One caveat before you get too comfortable: in 2022's inflation shock, even they fell alongside stocks. No hedge works every time. 🐜
The rest of this unit
The only free lunch in investing, and the fine print nobody reads.