The basic premise behind diversification is easy enough to understand: Spread your investments among assets that react differently to market events, so that if something bad happens your investments don't all crash at the same time.
But how do you determine whether two assets will behave differently? How do you measure it?
That's where a statistical concept called correlation comes into play. Now the math is pretty complicated, but while it's not essential to memorize the formula, it's important to understand what correlation is since it often comes up in financial media or in discussions with your advisor.
Put simply, correlation is the degree to which the movements of two variables are associated with each other. In our case, that means the degree to which two investments have moved in tandem throughout their history in relation to their respective average.
It's expressed as a number between -1 and 1. A correlation of 1 means the two investments have always moved in the same direction relative to their average return. Two Canadian equity funds that both stay very close to the same benchmark, for example, would likely have a correlation near 1.
Note that a high correlation doesn't necessarily mean the two investments will have similar returns. It only means that when one performs better than its own average, the other one is probably doing so as well, and vice-versa.
When building a portfolio, the ideal situation is finding investments that have very low correlations with each other, so that at any given time, a few of them will be losers, but most of them will be winners.
