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Correlated Asset Returns
Definition
Correlation between asset returns measures the degree to which two asset classes move together. A correlation of +1.0 means they move in perfect lockstep; 0.0 means no relationship; -1.0 means perfect opposition. In reality, most risky assets exhibit positive correlations that increase during market stress — the "correlation to one" phenomenon during financial crises. A correlation matrix captures all pairwise relationships across the portfolio's asset classes and is a critical input to any simulation that aims to produce realistic risk estimates.
In the Context of Endowment Management
The assumptions embedded in the correlation matrix are among the most consequential inputs to endowment simulation. Underestimating correlations between private equity and public equity, for example, would lead to underestimating portfolio drawdown risk — a dangerous blind spot for fiduciary decision-making. Capital market assumptions should be reviewed and updated periodically to reflect current correlation estimates.