Why Asset Correlations Spike During Financial Crises

In calm markets, diversification feels comforting. Stocks move on earnings, bonds react to rates, commodities follow supply and demand, each asset seems to live in its own world. But when markets come under stress, that sense of independence often disappears. Assets that normally behave differently suddenly start moving together, usually downward. This jump in correlation is one of the most frustrating experiences for investors, because it shows up exactly when protection is needed most. What looked like a balanced portfolio can begin to feel like a single risky bet.

The main reason this happens is that big, systemic forces take over during crises. In periods of panic, markets stop focusing on company-specific or sector-specific stories and start reacting to the same macro fears, recession, credit risk, inflation shocks, or financial instability. Academic research shows that as volatility rises, asset returns become increasingly driven by these common factors, pushing correlations higher across markets. In other words, individual differences matter less when everyone is responding to the same threat.

Human behaviour also plays a powerful role. During market stress, investors tend to act together, selling risky assets, reducing leverage, and moving into cash or perceived safe havens. This “rush for the exit” is often intensified by margin calls and fund redemptions, forcing institutions to sell multiple assets at the same time. Even assets with little economic connection can fall in tandem, not because their fundamentals changed, but because liquidity is being pulled out everywhere at once. This process, known as financial contagion, helps explain why correlations spike so quickly in crises.

History provides clear evidence of this pattern. Studies examining past crises, including sovereign debt scares and global equity sell-offs, consistently find that correlations rise sharply as markets fall. In some cases, even traditionally defensive assets temporarily move in sync with riskier ones. Research on cross-market behaviour shows that diversification works best in stable conditions, but weakens as stress deepens and fear becomes the dominant market driver.

The lesson for investors is a sobering one. Correlations are not fixed numbers; they change with market conditions and investor psychology. Portfolios built on the assumption that assets will always move independently can underestimate risk during turbulent times. Recognizing that correlations tend to rise in stress helps investors think more realistically about risk management, and reminds them that true diversification is hardest to achieve when it matters most.