Ignore Shifting Correlations At Your Peril

September 24, 2014

The Impact On Portfolio Construction

The correlation between stocks and bonds can have a large impact on asset allocation decisions, especially in the context of risk management.

Using equity figures from the Fama/French research library and bond figures from Antti Ilmanen's book "Expected Returns," we will assume the following long-term dynamics:

Expected Excess Return Excess Return Volatility
U.S. Stocks 8.35% 20.78%
U.S. Bonds 1.17% 6.69%

From these dynamics, we can solve for optimal Sharpe ratio portfolios based on varying correlation assumptions:

Stock_Bond_Sharpe_Ratio_Allocation

Moving from the pre-1998 average correlation of 0.28 to the post-1998 average correlation of -0.28 results in a 12.5 percentage point decrease in recommended equity allocation for the maximum Sharpe ratio portfolio.

However, investors don't invest in the Sharpe optimal portfolio, but rather along the efficient frontier, as they are either seeking a target return level or a specific risk level.

While expected excess return levels will be independent of correlation, portfolio volatility will be dependent upon it and therefore, for risk-sensitive investors, correlation is a key ingredient of the decision-making process.

 

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