Investing

Which Assets Provide Less Diversification? Understanding Correlation Risk

Which Assets Provide Less Diversification? Understanding Correlation Risk

The year 2022 showed how quickly correlation risk can surface. Inflation climbed, central banks raised interest rates, and both U.S. and international equities declined sharply. The S&P 500 dropped about 18%, while the MSCI ACWI ex USA IMI fell 16.15%.

For many investors, portfolios that appeared balanced on paper failed to deliver the expected protection. Correlations across global equities rose, undermining the benefits of diversification. The Bank for International Settlements (BIS) has noted that during periods of stress, cross-market co-movements often intensify, leaving portfolios more vulnerable than investors anticipate.

This makes it critical to use tools that can detect correlation risks before they show up in performance results.

Key Takeaways

  • Simply owning more holdings doesn’t guarantee protection if those assets move in sync.
  • Large-cap tech stocks, certain cryptocurrencies, and sector-specific ETFs often display high correlation.
  • Correlation risk tends to climb during crises, shrinking diversification benefits.
  • Monitoring overlap and exposures can help investors build portfolios with genuinely distinct risks.

The Myth of “More is Safer”

It’s common to assume that a larger number of positions means greater diversification. But what matters more than the count is correlation — the degree to which assets move together.

In calm markets, correlations may appear low. But in downturns, many assets begin moving in the same direction, so portfolios that seemed diversified can behave like one concentrated bet — often at the worst possible time.

Frequent Culprits: Assets That Often Move in Tandem

Some asset classes tend to follow the same patterns, limiting diversification:

  • Large-cap tech stocks — Even across different industries (e.g., software vs. social media), many respond similarly to shifts in interest rates or market sentiment.
  • Cryptocurrencies — Despite the variety of tokens available, most tend to track Bitcoin’s movements, especially during sell-offs.
  • Sector-focused ETFs — Funds tied to a single industry, such as financials or energy, typically mirror sector performance and may share overlapping holdings.

When Correlation Risk Rises

Hypothetical example: An investor holds several large-cap tech stocks, a tech-focused ETF, and a leading cryptocurrency. If higher rates spark a market correction, all of those positions could decline at once. The size of the drawdown wouldn’t reflect the number of holdings but their overlapping exposures.

Imagine three of the top five positions in a portfolio each falling 25%. The impact could overshadow the appearance of diversification. The CFA Institute highlights that correlations often surge in crises, as investors sell risk assets broadly. Correlation is not constant — it evolves with market cycles, shocks, and shifts in behavior.

Keeping an Eye on Overlap

Many investors turn to platforms like PortfolioPilot.com to measure diversification, evaluate sector exposure, and identify when multiple holdings share the same risks. These tools can flag redundancy before it undermines portfolio resilience. Even without advanced software, investors can:

  • Review sector weights in ETFs or mutual funds
  • Look at historical correlation data for key holdings
  • Compare how investments performed in prior downturns

Because correlations change over time, these checks should be done regularly. Assets that appear uncorrelated today can move almost in lockstep in the next period of stress.

  • Insight: Effective diversification isn’t about collecting more positions — it’s about holding exposures that truly behave differently. Reducing correlation risk and reviewing it periodically helps ensure a portfolio is designed to withstand changing market conditions.

Correlation Risk and Diversification — FAQs

Why did portfolios that appeared diversified suffer in 2022?
Global equity correlations spiked during stress, causing assets that normally behave differently to move together, which eroded diversification benefits.
What does correlation risk mean for investors holding multiple positions?
Correlation risk occurs when assets that appear distinct move in sync, creating the effect of a single concentrated bet during downturns.
Which equity sectors are most prone to moving together?
Large-cap technology stocks often trade in tandem, as interest rate changes or advertising trends can drive multiple firms despite differing industries.
How do cryptocurrencies typically behave during market sell-offs?
Many digital assets show high correlation with Bitcoin, often falling together when broader crypto markets face stress.
What happens when an investor owns multiple correlated assets like tech stocks, ETFs, and crypto?
Rising interest rates or a correction could trigger simultaneous declines across all holdings, magnifying drawdowns despite owning several tickers.
How do sector-specific ETFs contribute to correlation risk?
Funds concentrating on a single industry, such as energy or financials, usually move in line with sector performance, limiting diversification benefits.
What role do stress periods play in asset correlations?
Stress episodes often increase co-movement across markets as investors liquidate risk assets indiscriminately, compressing diversification benefits.
How can an investor detect whether diversification is overstated?
Monitoring overlap through sector weightings, historical correlation data, and performance in past downturns can highlight hidden concentration risks.
Why is correlation not a static measure in portfolio construction?
Asset relationships shift with market cycles, economic shocks, and investor behavior, meaning today’s low correlation can vanish in the next crisis.
What tools are available for monitoring correlation risk?
Platforms such as AI-driven analyzers can calculate diversification scores, highlight overlapping risk drivers, and simulate how portfolios may behave under stress.