Correlation Clustering
Grouping assets or signals by correlation structure to manage diversification and risk.
Definition
Correlation clustering (or hierarchical clustering on correlation/distance) groups assets that move together. Useful for portfolio construction (diversify across clusters) and risk (avoid over-concentration in one cluster).
Why it matters
- Equal weight across 10 assets that are highly correlated gives little diversification.
- Clusters can correspond to sectors, regions, or risk factors.
Common mistakes
- Using correlation in trending regimes (correlation is not stable).
- Treating cluster count as fixed; it can change over time.
- Ignoring that correlation is not a distance (use ( 1 - \rho ) or similar for clustering).
Typical use
Define clusters, then equal weight within cluster and across clusters; or use for constraint (max weight per cluster).