The stock-bond relationship and volatility

The stock-bond relationship is the most important in all of asset allocation work. Stocks and bonds are the two major asset classes that all investors hold. Call it the core holdings. The success or failure of asset allocation will be driven by how this relationship changes through time and how investors make their weighing allocation. A FRBNY staff paper, Flight-to-safety in the nonlinear risk-return tradeoff for stocks and bonds, focuses on one area of this allocation question, the link between stocks and bonds with volatility.

The result show that there is a high degree of sensitivity between stock and bond returns and changes in volatility, but the form of that relationship is highly nonlinear. As volatility rises stocks will do better on a risk-adjusted basis, but at some level there will be a significant decline in returns. There is "too much"volatility and there is a flight to safety into bonds. At low volatility markets may favor bonds or be indifferent between the two asset classes. This story is consistent with what we have seen with the VIX as a "fear index" Small increases will not matter but at some point, fear takes over.  This  pattern is similar across many equity and bond sectors.

Dynamically adjusting stock and bond allocations to volatility is a simple way to add value to any asset allocation decision process. Just don't use a linear approach but focus on thresholds for portfolio adjustments.