Investors are always advised to have well-diversified portfolios, including different companies, sectors, geographies, currencies and asset classes. The aim is to reduce downside risk, so if one holding starts to lose value, other holdings either do not fall by the same amount as they are driven by different factors, or they even perform well. But the effectiveness of this diversification entirely depends on how closely correlated the holdings are to one another.
Correlation between assets can be measured using the correlation coefficient, which has a value between -1 and 1. A perfect negative correlation of -1 would occur when two assets move in opposite directions 100 per cent of the time; when one falls the other rises by the same amount and vice versa. This tells us that it is highly likely that whatever factors negatively affect one holding will be positive for the other.
A perfect positive correlation of 1 is when two assets always move in the same direction and by the same amount, and so it is likely the two holdings are affected by the same things. A reading of 0, or very close to 0, shows no relationship at all.