Diversification is a vital part of investing success, but there are signs that it’s getting harder as markets become more volatile.
Effective asset allocation, such as dividing a portfolio between bonds and stocks, is used to enhance returns when markets are rising and protect capital and reduce risk when they are falling. Investors want assets that operate in different ways to each other in different market conditions. A key concept here is correlation*, the extent to which securities move in similar or different directions. When one part of your portfolio is falling, a rise in another part can balance out total returns.
But asset allocation is not always easy, especially during phases of high volatility such as in April when the US government announced tariffs on global trade partners.
“In times of uncertainty, correlations between asset classes tend to increase, and this particularly applies to equity markets,” explains Nicolò Bragazza, associate portfolio manager at Morningstar Wealth.
“Since investments in the same asset class, such as equities, tend to have higher correlations precisely in times of stress where diversification is most needed, investors look for investments with different characteristics to mitigate this phenomenon.”
Asset allocation should not only be judged by performance, but also by the balance it manages to strike between risk and return over the long term.
Correlation Between Asset Classes Is Increasing
Here we have looked at 14 major Morningstar Categories over three different time horizons: in the first four months of 2025, in 2024, and in 2023:
- EUR corporate bond
- EUR government bond
- EUR high yield bond
- EUR inflation-linked bond
- USD corporate bond
- USD high yield bond
- USD diversified bond
- Emerging markets bond
- Europe large cap blendequity
- Japan large cap equity
- US large cap Blend equity
- Asia-Pacific ex-Japan equity
- Latin America equity
- Commodities precious metals
Looking at the tables, the correlation between the various asset classes since the beginning of the year have increased significantly, especially for certain categories: the greener the box, the higher the correlation; conversely, the more the box tends to red, the more the coefficient will be negative. This implies that it’s been harder for investors to diversify in more volatile and unpredictable markets.
Which Categories Are Negatively Correlated?
After equity and bond categories had increased their correlation coefficients in 2023 compared with previous years, some divergence was seen again during 2024, particularly in the Europe, Asia-Pacific, and Latin America equity categories, as well as inflation-indexed euro bonds. Last year there were as many as 17 inverse correlations.
In the first four months of 2025, however, we see only one negative correlation, that between euro government bond funds and Europe large-cap equity funds.
Negative correlations can be useful for investors: if one part of the portfolio rises 10% when another falls 10%, this is described as perfect negative correlation. In practice, this is very hard to achieve.
In particular, products exposed to gold seem to have lost their natural role as portfolio diversifiers. While precious metals exchange-traded commodities showed only three weakly positive correlations during 2024. In early 2025 there are no negative or null correlations. This year the price of gold has hit new record highs.
The same trend is noticeable with Latin America equity funds, which have been much less “diversifying” in these early years. For example, this category has seen its correlation coefficient with Japan equity funds rise from negative 0.54 last year to positive 0.27 this year.
“Correlations, however, may not fully capture the diversifying potential of an investment,” Morningstar’s Bragazza says. “For example, although correlations in LatAm equities have increased since last year, Brazilian and Mexican equities have offered positive returns since the beginning of the year, while global equities are in negative territory, highlighting that although correlations are positive these have not translated into a lack of diversification.”
Beware of the Currency Effect
Correlations between US and European bond categories are affected by the dollar effect. During 2024, the euro depreciated sharply against the dollar, while the trend was exactly the reverse in early 2025. On April 21, the euro touched its three-year high at $1.15, before dropping again to $1.11 after the US-China trade deal was announced.
This had the effect of increasing the correlation between the categories devoted to European or eurozone equities and those of US bond categories.
“The depreciation of the dollar has affected all correlations,” says Bragazza. “If we take Brazilian equities, their correlation in local currency or in euros is different (and higher in euros) in relation to bonds in euros, dollars or even toward European and American equities.”
“In the long run, however, the effect of currencies is less evident, as is that of sentiment, and so correlations tend to express more co-movements in fundamentals, and this is reflected in higher correlations between riskier asset classes, such as equities and high-yield bonds,” adds Bragazza.
How Correlation Works and Why it Matters
The work of late Nobel laureate Harry Markowitz on modern portfolio theory looked at why the more a financial portfolio is composed of securities of different properties (such as sectors or style biases), the more the degree of risk is lowered.
Deciding how much of a portfolio to devote to equities, bonds, or other assets depends on correlation, which identifies how closely two assets track each other’s movements. This is expressed as a number between negative 1 and positive 1.
A coefficient of 0 indicates that there is no correlation between the two funds. A coefficient of 1 indicates that there is a perfect positive correlation, which means that the two instruments move together: if one rises by 10%, the other does too, and vice versa. Obviously, in the case of perfect negative correlation (equal to negative 1) the ratio is inverse: if the first rises by 10%, the second loses 10%.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
