Correlation

Correlation measures whether two sets of returns rise and fall at the same time. At 1 they move in step, at 0 their moves are unrelated, and at minus 1 one rises exactly when the other falls. It describes whether the moves line up, not how large they are.

It is the mechanism behind diversification. Two holdings that swing by the same amount swing less in combination than either does alone, unless their correlation is exactly 1, and the lower it is the larger the reduction. That is why the number of holdings matters less than how differently they behave.

Correlations are not constants. Measured over calm years they can look low, then rise sharply in a crisis, when many assets fall together. Stocks and US Treasury bonds offset each other in most years after 2000 and then fell together through 2022, when rising rates drove both.