MT423 Unit 4 Asset Class Review Example

The Correlation That Moved in 2022: An MT423 Unit 4 Asset Class Review of Six Classes

[Student Name]

Purdue University Global

MT423: Asset Allocation and Risk Management

Unit 4 Asset Class Review

[Instructor Name]

[Date]

Expected returns, volatilities and correlations are composite assumptions supplied for the exercise, modeled on the form of published capital market assumptions; the 2022 index returns are real, and the sources cited are real.

Forward-Looking Assumptions

The assumptions are forward-looking estimates of the kind investment firms publish each year, supplied for the course and labeled as such, not historical averages. U.S. stocks are assumed to return 6.5 percent a year with volatility of 16 percent. Developed international stocks are assumed at 7.0 and 17 percent, real estate investment trusts at 6.8 and 20, core U.S. bonds at 4.5 and 6.0, inflation-protected Treasuries at 4.3 and 6.5, and cash at 3.2 and 1.0.

Historical and forward-looking figures should not be mixed in one table. A historical average describes what happened over a particular period; an assumption describes what an analyst expects from today's starting yields and valuations. The 2022 figures later in this review are historical and are kept separate.

Return per Unit of Risk

Dividing each class's expected return above cash by its volatility gives a rough measure of reward for risk. U.S. stocks score 0.21, developed international 0.22, real estate trusts 0.18, core bonds 0.22 and inflation-protected Treasuries 0.17. The ratios cluster between 0.17 and 0.22, which means no class dominates the others on its own. No single class stands out, so whatever argument there is for holding several has to come from the way their swings offset.

The Correlation Matrix

The assumed correlations are high among the risky equity classes: 0.85 between U.S. and international stocks, 0.75 between U.S. stocks and real estate trusts, and 0.70 between international stocks and real estate trusts. Core bonds are assumed nearly uncorrelated with stocks, at 0.05, and with real estate trusts at 0.15. Inflation-protected Treasuries are assumed at 0.20 with stocks and 0.75 with core bonds. Cash is close to uncorrelated with everything.

Correlation Doing the Work

A fixed mix of 60 percent U.S. stocks and 40 percent core bonds shows how much correlation matters. Its expected return does not depend on correlation, but its volatility does. At a correlation of minus 0.2, the mix's volatility is 9.42 percent. At zero it is 9.90 percent. At plus 0.5 it is 11.00 percent. The same two classes in the same proportions carry about 17 percent more volatility when they move together than when they move slightly apart.

Ilmanen (2003) found that stock-bond correlations have changed considerably over time, tending to be positive when inflation is high and uncertain and negative when growth fears dominate. Campbell et al. (2017) traced the shift to how inflation and real rates affect both markets. A correlation is an estimate for a period, not a fixed property of the two markets.

2022 as the Test Case

Calendar 2022 showed what happens when that estimate breaks. The S&P 500 lost 18.11 percent on a total-return basis (S&P Dow Jones Indices, 2025), while the broad investment-grade bond benchmark, the Bloomberg U.S. Aggregate, fell 13.01 percent, its worst year on record, as inflation and rising rates pushed down both stocks and bond prices at once. A 60/40 mix of the two would have lost about 16.07 percent. In most earlier downturns of the previous two decades, bonds had risen while stocks fell; in 2022 they did not.

The diversification a 60/40 mix counts on came from a correlation that turned positive in exactly the year it was needed.

Real Estate Trusts

Real estate investment trusts are often presented as a separate source of diversification. Under these assumptions their correlation of 0.75 with U.S. stocks means they behave much like a sector of the stock market. They add some exposure to rents and property values, but in a crisis they have tended to fall with stocks, often further. Their place in a portfolio should be justified by their return and income, not by diversification they do not provide.

Inflation-Protected Treasuries

Inflation-protected Treasuries adjust their principal with consumer prices, which protects purchasing power if they are held to maturity. They are not riskless before maturity. Their prices fall when real interest rates rise, and in 2022 real yields rose so sharply that inflation-protected Treasury funds lost about as much as ordinary bond funds despite record inflation. Their value for a retiree is protection of real spending power over time, not stability from year to year.

Cash

Cash carries almost no volatility and a modest expected return. Its role is liquidity, money to spend without selling other assets at a bad time, rather than return.

What the Review Implies for Denise

For Denise Hartley, whose capacity limit from Unit 3 is about 28 percent of current assets, the review points to two conclusions. First, the loss limit should be tested against a year in which stocks and bonds fall together, not only against a year in which bonds cushion a stock decline. Second, the classes that most reduce risk in a mix are core bonds and cash, because of their low correlation with stocks, while real estate trusts add less diversification than their label suggests. The strategic allocation in Unit 5 will use these assumptions and test each candidate against both kinds of crisis.

References

Campbell, J. Y., Sunderam, A., & Viceira, L. M. (2017). Inflation bets or deflation hedges? The changing risks of nominal bonds. Critical Finance Review, 6(2), 263-301. https://doi.org/10.1561/104.00000043

Ilmanen, A. (2003). Stock-bond correlations. Journal of Fixed Income, 13(2), 55-66. https://doi.org/10.3905/jfi.2003.319353

S&P Dow Jones Indices. (2025). S&P 500. https://www.spglobal.com/spdji/en/indices/equity/sp-500/