Rethinking the Stock-Bond Correlation: A Long-Term Investor's Perspective

In a thought-provoking keynote speech at the Fiduciary Investors Symposium, Stanford University Professor of Finance John Cochrane challenged the conventional wisdom surrounding the assessment of stock-bond correlations. Cochrane argued that the traditional models used by investors to determine these correlations are based on several "implicit assumptions" that may not accurately reflect the needs and concerns of long-term investors.

Uncovering the Flaws in the Conventional Approach

Cochrane highlighted that the conventional approach to assessing stock-bond correlations assumes a specific type of investor – one who is primarily concerned with the mean-variance of their portfolio, holds only the market portfolio of stocks, and has no other income, liabilities, or job-related considerations. However, Cochrane contends that this assumption is particularly problematic when it comes to understanding the role of bonds in a long-term investor's portfolio.

The Unique Characteristics of Bonds

Cochrane emphasized that the fundamental nature of bonds is often overlooked in the conventional models. He pointed out that when the price of a long-term bond goes down, its yield goes up, and over the long run, the investor can expect to recoup any losses. For a long-term investor with no immediate cash needs, this characteristic of bonds can be a significant advantage, yet it is not adequately captured by the traditional mean-variance approach.

Considering Economic Fundamentals

Instead of relying solely on statistical models, Cochrane encouraged investors to look at the economic situations that determine whether bonds serve as a hedge or a risk. He argued that the key question is not just whether bonds are hedges or risks, but whether the investor is in a better position to hedge or take on risk compared to the average market participant.

Lessons from the 2008 Financial Crisis

Cochrane cited the 2008 financial crisis as a classic example of bonds serving as a hedge. With inflation and interest rates both declining, long-term government bonds experienced a boost in both price and real value, even as other assets were faltering. However, Cochrane warned that long-term bonds can also be a risk when inflation becomes a factor, as evidenced by the impact of the $5 trillion US government fiscal expansion during the COVID-19 pandemic.

Embracing a Simpler Mindset

Rather than focusing on the fixed nature of stock-bond correlations, Cochrane suggested that investors would be better served by adopting a simpler mindset. This involves finding a stable economic structure and understanding how changing times and different types of shocks can impact the relationship between stocks and bonds.

Considering the Investor's Needs

Cochrane acknowledged that the research view on the importance of the volatility of inflation and growth in determining stock-bond correlations may be relevant for certain types of investors, such as those engaged in high-frequency trading or leveraged positions. However, for long-term investors, Cochrane emphasized that the focus should be on setting up a portfolio that aligns with the economic risks their clients can handle, rather than constantly buying and selling at high frequencies.In conclusion, Cochrane's insights challenge the conventional approach to assessing stock-bond correlations and encourage long-term investors to adopt a more nuanced and fundamental-driven perspective. By considering the unique characteristics of bonds, the economic factors that influence their role as hedges or risks, and the specific needs of their clients, investors can better navigate the complexities of the stock-bond relationship and make more informed decisions for their long-term portfolios.