Diversification is measured in calm conditions and relied upon in stressed ones. That is the problem in a sentence: the correlations that make a portfolio look diversified are exactly the ones that stop holding when it matters.
The mechanism is straightforward. In calm periods each asset responds mainly to its own drivers, so correlations are low. In stress, participants need cash and reduce risk across everything they hold. That single force acts on all positions simultaneously, so previously unrelated assets move together.
| Holding | Behaviour in a liquidity event |
|---|---|
| Equities across sectors | Correlations converge toward one |
| Corporate credit | Falls with equities; liquidity often disappears |
| Government bonds | Often rise, though not in an inflation-driven stress |
| Cash | Reliably retains nominal value and optionality |
| Gold | Mixed — sometimes sold for liquidity, sometimes bid |
Common belief
"My portfolio has a low correlation matrix, so it is diversified."
What is actually true
A correlation matrix is a backward-looking average over a chosen window. It tells you what happened, mostly in calm periods that dominate the sample. Stress correlations are systematically higher than the average the matrix reports, so the matrix overstates diversification exactly where it matters.
Cash is the most underrated diversifier. It has no upside, which is why it is dismissed, and it retains value and optionality in precisely the conditions where everything else is falling together. Holding some deliberately is a position, not an absence of one.