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The Stock-Bond Correlation

Megan Czasonis, Mark Kritzman and David Turkington
The Journal of Portfolio Management February 2021, 47 (3) 67-76; DOI: https://doi.org/10.3905/jpm.2020.1.195
Megan Czasonis
is a managing director at State Street Associates in Cambridge, MA
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Mark Kritzman
is the chief executive officer at Windham Capital Management in Boston, MA, and a senior lecturer at the MIT Sloan School of Management in Cambridge, MA
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David Turkington
is a senior managing director at State Street Associates in Cambridge, MA
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Abstract

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 methods

Key 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.

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The Journal of Portfolio Management: 47 (3)
The Journal of Portfolio Management
Vol. 47, Issue 3
February 2021
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The Stock-Bond Correlation
Megan Czasonis, Mark Kritzman, David Turkington
The Journal of Portfolio Management Jan 2021, 47 (3) 67-76; DOI: 10.3905/jpm.2020.1.195

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The Stock-Bond Correlation
Megan Czasonis, Mark Kritzman, David Turkington
The Journal of Portfolio Management Jan 2021, 47 (3) 67-76; DOI: 10.3905/jpm.2020.1.195
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  • Article
    • Abstract
    • SINGLE-PERIOD CORRELATION
    • FUNDAMENTAL PREDICTORS OF THE STOCK–BOND CORRELATION
    • SUMMARY
    • ENDNOTES
    • REFERENCES
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