Toby Watson on What Rising Correlations Between Asset Classes Mean for Investors
When the assets investors rely on for diversification begin moving together rather than independently, the implications for portfolio construction are significant — and Toby Watson brings to this subject a perspective shaped by direct experience of how correlation dynamics shift across different market environments.
Rising correlations between asset classes represent one of the more underappreciated risks in modern portfolio management. When assets assumed to move independently begin moving in the same direction simultaneously, the diversification benefits investors have built their portfolios around can disappear precisely when they are needed most. Toby Watson, whose career spans structured credit, global principal funding and investment management across multiple market cycles, offers a grounded perspective on what rising correlations mean in practice — and what they require of investors who take portfolio resilience seriously.
When Diversification Assumptions Break Down
The foundational logic of diversified portfolio construction rests on the assumption that different asset classes respond differently to the same economic conditions. These relationships have genuine empirical support over long historical periods — but they are not constants. They shift as the macroeconomic environment shifts, and the periods in which they break down most dramatically tend to be precisely those in which investors most need them to hold.
The clearest recent example is the behaviour of equities and bonds in 2022. For most of the preceding two decades, the two asset classes had displayed a reliably negative correlation. That relationship reflected a specific macro environment — one in which the primary driver of equity weakness was slowing growth rather than rising inflation. When the macro driver changed, the correlation turned positive and both asset classes fell together. For Toby Watson, this episode illustrates how correlation is regime-dependent rather than structurally fixed — and why treating historical correlation statistics as reliable guides to future portfolio behaviour is a form of risk that deserves more attention than it typically receives.
Reassessing diversification assumptions requires examining the underlying drivers of return for each asset — not just historical correlation statistics. Toby Watson, whose time at Goldman Sachs gave him extensive experience of analysing how different instruments behave across changing macro regimes, would suggest the key question is whether the factors that historically produced low or negative correlation between holdings still apply in the current environment. For Toby Watson, correlation statistics drawn from a different macro regime can be actively misleading — and that is a risk investors should take seriously rather than dismiss as a theoretical concern.
Toby Watson on the Drivers of Correlation Shifts
Understanding what causes correlations to rise — and when they are most likely to do so — is important context for building portfolios that are genuinely resilient rather than merely diversified in appearance.
The most important driver of correlation shifts is the prevailing macro regime. In growth-driven downturns, equities tend to fall while safe-haven assets rise — producing the negative correlations that traditional diversification relies upon. In inflation-driven downturns, both equities and bonds can fall simultaneously. For Toby Watson, understanding which macro regime is in operation — and how likely it is to persist — is foundational to assessing whether existing diversification assumptions remain valid. Toby Watson would note that this assessment needs to be revisited regularly, rather than made once and left unchanged.
A second important driver of rising correlations is acute liquidity stress. When investors face urgent needs to raise cash, they tend to sell whatever they can be regardless of asset class — producing sharp, sudden increases in correlations across virtually all risky assets. Among the practical implications for portfolio construction are:
- The importance of maintaining a meaningful allocation to genuinely liquid assets that can be accessed quickly without materially affecting their price
- The recognition that correlation-based diversification offers the least protection during liquidity crises — when the need for protection is greatest
For Toby Watson, whose professional experience at Goldman Sachs encompassed credit markets where liquidity dynamics are a central risk management consideration, understanding this mechanism is an important part of building portfolios that are robust under stress rather than merely under normal conditions.
Practical Responses to a World of Rising Correlations
Acknowledging that correlation assumptions can break down does not mean abandoning diversification — it means pursuing it more carefully and with a clearer understanding of its limits. The most practical responses involve a shift in how diversification is conceptualised: away from simple asset class spread and towards genuine independence of underlying return drivers.
For Toby Watson, the relevant disciplines are clear. First, assess the macro regime dependency of each diversification relationship — asking explicitly whether historical correlation between holdings reflects a structural feature or a regime-specific one. Second, stress-test the portfolio against scenarios in which correlations between major holdings increase simultaneously. Toby Watson would add that this kind of stress-testing is most valuable when done before conditions deteriorate — not as a reactive exercise after correlations have already begun to rise.
Building Portfolios That Acknowledge Correlation Risk
Among the structural approaches that tend to help investors manage correlation risk more effectively are:
- Genuine factor diversification — ensuring different holdings are exposed to different underlying return drivers, rather than relying on asset class labels that may mask shared sensitivities
- Explicit scenario analysis around correlation breakdown — assessing how the portfolio would behave not just under the base case but under conditions in which assumed diversification benefits fail to materialise
The central insight that Toby Watson — drawing on his career at Goldman Sachs and his subsequent work as a partner at Rampart Capital — would bring to this subject is straightforward: correlations are not portfolio constants, they are variables. For Toby Watson, building genuine resilience means designing portfolios that remain coherent even when those variables move in unfavourable directions — a discipline which begins well before market conditions make it urgent.
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