Expected returns, correlations, and optimal asset allocations

Abstract

With increasing uncertainties in financial markets, individual investors now face difficult asset allocation choices. This article provides a framework for this deliberation by examining the marginal effects of the key input variables in the asset allocation for a portfolio of stocks, bonds, and bills. Expected stock returns are positively related to the optimal weight on stocks, but we show that the magnitude of this relation depends upon both the expected stock-bond correlation and the investor's attitude toward risk. We also find that an increase in the expected stock-bond correlation leads to shifts from bonds to bills for more risk-averse investors.