Factor Advisors recently released its 2011 Correlation Report that highlights the relationship (or lack thereof) between different asset classes on Wall Street. And the findings are startling, and worth noting to any investor trying to build a diversified portfolio.

Factor Advisors defines correlation as ” a statistical measure of how two securities or assets move in relation to each other, ranging between -1 (move perfectly in opposite directions) and +1 (move perfectly in the same direction), with a correlation of 0 indicating a random relationship.”

Here’s what they found:

 2011 was a year of extremes for cross-asset correlations

• U.S. Treasury Bonds vs. S&P 500 correlation was -0.81, a 13-year low
• The U.S. Dollar vs. S&P 500 correlation was -0.53, nearing a 30-year low
• The correlation between large-cap U.S. stocks and other stock segments (small-cap U.S., non-U.S., emerging, value and growth stocks) continued to rise, approaching +1 in many instances
• Rising correlations among portfolio holdings can reduce diversification benefits and increase overall portfolio volatility
• Given continued uncertainty in European and U.S. markets, investors expecting heightened market volatility in 2012 should expect correlation extremes to persist

Most of the ten asset classes (illustrated at right) are at either the highest or lowest correlations to the S&P 500 in the last ten years.  With correlations moving toward relative extremes, either strongly positive or strongly negative, assets can be defined as either “risk on” or “risk off” assets.

With cross-asset correlation in 2011 at relative extremes, it should be noted that correlations historically do not remain at extremes.  If volatility subsides, it can be anticipated that correlations would revert back to historical averages.  Given continued uncertainty in European and U.S. markets, however, investors should be prepared for more volatility in 2012 and high correlation across many “risk on” asset classes.