RT Journal Article
SR Electronic
T1 The Stock-Bond Correlation
JF The Journal of Portfolio Management
FD Institutional Investor Journals
SP 67
OP 76
DO 10.3905/jpm.2020.1.195
VO 47
IS 3
A1 Czasonis, Megan
A1 Kritzman, Mark
A1 Turkington, David
YR 2021
UL http://jpm.pm-research.com/content/47/3/67.abstract
AB Investors rely on the stock-bond correlation for a variety of tasks, such as forming optimal portfolios, designing hedging strategies, and assessing risk. Most investors estimate the stock–bond correlation simply by extrapolating the historical correlation of monthly returns; they assume that this correlation best characterizes the correlation of future annual or multiyear returns, but this approach is decidedly unreliable. The authors introduce four innovations for generating a reliable prediction of the stock-bond correlation. First, they show how to represent the correlation of single-period cumulative stock and bond returns in a way that captures how the returns drift during the period. Second, they identify fundamental predictors of the stock-bond correlation. Third, they model the stock–bond correlation as a function of the path of some fundamental predictors rather than single observations. Finally, they censor their sample to include only relevant observations, in which relevance has a precise mathematical definition.TOPICS: Portfolio management/multi-asset allocation, risk management, statistical methodsKey Findings▪ The stock-bond correlation is a critical component of many investment activities, such as forming optimal portfolios, designing hedging strategies, and assessing risk.▪ Most investors estimate the correlation of longer-interval returns by extrapolating the correlation of past shorter-interval returns, but this approach is decidedly unreliable.▪ By applying recent advances in quantitative methods, it is possible to generate reliable predictions of the correlation of longer-horizon stock and bond returns.