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After constructing a diversified allocation, we advise investors to review their holdings regularly. Adhering to an appropriate investment objective may help to mitigate risk while potentially offering a favorable return over the long term. The table below illustrates the differences that annual rebalancing can make during a 25-year period after starting with a 60% U.S. equity and 40% U.S. bond allocation. When rebalancing, 19% less volatility was experienced while achieving a similar risk-adjusted return to that of an allocation that was not rebalanced. Additionally, we expect that an allocation mix with exposure to a wide variety of asset classes may smooth performance over time.
With that in mind, when investors review portfolio holdings they should:
Over time, specific asset classes may become overvalued or undervalued. We believe rebalancing the portfolio back to strategic target weights regularly can help reinforce the discipline of purchasing risk assets when they appear undervalued (inexpensive) and selling risk assets when they appear overvalued (expensive). In other words, this approach aims to facilitate the potential for buying low and selling high. Moreover, investors should not let emotional reactions to headline hyperbole or unfounded market fears derail a disciplined investment strategy. In our view, investors who attempt to time the market — or react to an isolated market event or overstated headline — may get caught on the wrong side of a market move.
Our analysis has found that a diversified allocation has outperformed global equities (represented by MSCI All Country World Index) and global bonds (represented by Bloomberg Multiverse Index) on a risk-adjusted basis over the long term. Yet, the rankings of specific asset class returns may fluctuate over short time frames. As the quilt chart below illustrates, in any given year, one asset class will outperform all others. The top-performing and worst-performing asset classes typically change from year to year. Despite that, we believe that investors should maintain a diversification strategy that matches their risk and return objective profile. A diversified allocation, such as Moderate Growth and Income, may limit portfolio drawdowns. Moreover, this suggests that a diversified allocation does not have to work as hard to recover from significant market losses. Our findings also suggest that diversification may promote compounding through more consistent returns over time.
| 2020 | 2021 | 2022 | 2023 | 2024 |
|---|---|---|---|---|
| US Small Cap Equity 20.0% | US Large Cap Equity 28.7% | Commod 16.1% | US Large Cap Equity 26.3% | US Large Cap Equity 25.0% |
| Emg-Mkt Equity 18.7% | Commod 27.1% | Cash Alternative 1.5% | Dev ex US Equity 18.9% | US Mid Cap Equity 15.3% |
| US Large Cap Equity 18.4% | US Mid Cap Equity 22.6% | High Yield Fixed Inc -11.2% | US Mid Cap Equity 17.2% | US Small Cap Equity 11.5% |
| US Mid Cap Equity 17.1% | US Small Cap Equity 14.8% | Inv-Grade Fixed Inc -13.0% | US Small Cap Equity 16.9% | Mod Grwth Inc 10.5% |
| Mod Grwth Inc 14.8% | Dev ex US Equity 11.8% | Dev ex US Equity -14.0% | Mod Grwth Inc 13.7% | High Yield Fixed Inc 8.2% |
| Dev ex US Equity 8.3% | Mod Grwth Inc 10.2% | Mod Grwth Inc -14.7% | High Yield Fixed Inc 13.4% | Emg-Mkt Equity 8.1% |
| Inv-Grade Fixed Inc 7.5% | High Yield Fixed Inc 5.3% | Emg-Mkt Fixed Inc -16.5% | Emg-Mkt Fixed Inc 10.5% | Emg-Mkt Fixed Inc 5.7% |
| High Yield Fixed Inc 7.1% | Cash Alternative 0.0% | US Mid Cap Equity -17.3% | Emg-Mkt Equity 10.3% | Commod 5.4% |
| Emg-Mkt Fixed Inc 5.9% | Emg-Mkt Fixed Inc -1.5% | US Large Cap Equity -18.1% | Inv-Grade Fixed Inc 5.5% | Cash Alternative 5.3% |
| Cash Alternative 0.5% | Inv-Grade Fixed Inc -1.5% | Emg-Mkt Equity -19.7% | Cash Alternative 5.1% | Dev ex US Equity 4.3% |
| Commod -3.1% | Emg-Mkt Equity -2.2% | US Small Cap Equity -20.4% | Commod -7.9% | Inv-Grade Fixed Inc 1.3% |
In recent years, strong performance of U.S. equities has generally contributed to better performance for allocations oriented toward U.S. assets. For example, our current recommended strategic allocations have a relative overweight to U.S. Large Cap Equities at the expense of Developed Market ex-U.S. Equities compared with a global equity index, like the MSCI All Country World Index. If we were to expect the trend of U.S. equity outperformance to reverse, we could reduce U.S. Large Cap Equities in our strategic allocations but would likely retain a U.S. bias.
Looking at the risk-adjusted returns, or Sharpe ratios, in Table 2, our recommended diversified allocations fared better than global equities over the longer-term time frames shown. The strategic allocations are designed for a long-term time horizon, which means that global equities or global fixed income may outperform over a short time frame. Yet, over longer time periods, the blending of these two asset classes with Commodities has historically resulted in more efficient portfolios than holding a single asset class.
Asset class correlations play an important role in diversification and are key inputs in portfolio construction. Correlation describes the relation between asset classes. It reflects the degree to which two assets move in the same or opposite directions. Positively correlated assets tend to move in the same direction, and negatively correlated assets tend to move in the opposite direction.
Including assets with lower correlations adds more significantly to diversification within a portfolio, while higher correlations contribute less to the diversification benefits. Correlations among asset classes have tended to increase during significant market downturns.
As Table 3 illustrates, over extended periods, correlations typically have been lower as several market cycles may be included. When comparing correlations over the past 10 years and the past 25 years, the longer-term correlations show a better mix of lower- and higher-correlated asset classes, while the 10-year correlations were higher for most asset classes.
As Table 4 below illustrates, asset-class correlations have been elevated in recent years as the market has faced an aggressively hawkish Federal Reserve (Fed), interest-rate hikes, and an equity bear market.
Recently, volatility has returned to more historically normal levels, following a period of below-average market volatility for much of the decade prior to 2020. As volatility has risen, asset-class correlations also have trended higher, spiking in 2022 as fixed-income and equity markets declined in unison, and correlations have continued to creep higher. Alongside higher correlations among asset classes, diversified allocations have also exhibited volatility. We view low correlations as beneficial because they may potentially limit portfolio volatility.
Investors debate whether diversification works during a recession or a significant market selloff — when risk and fear roil markets and asset correlations increase significantly. Although we have observed correlations rise historically during periods of market stress, we also note that diversification across asset classes may have offered downside risk mitigation during such events.
To demonstrate why we believe diversification has historically worked well during calamitous events, we examined our current strategic allocations’ performance during various extreme downside events. We found that in down markets, the losses and volatility levels of diversified allocations were more subdued than those of the riskier asset classes.
One of the greatest benefits of diversification may be potentially mitigating some of the sharp downside of the riskier asset classes while maintaining an element of exposure to them for long-term growth potential. In other words, holding a more concentrated portfolio in risky assets may result in greater portfolio downturns when markets sell off. We believe that holding a diversified portfolio in an effort to mitigate downside risk could be advantageous despite higher correlations that we typically observe during times of market stress.
We believe that a well-diversified investment strategy can add value over the long term. It is important for investors to select a suitable strategic allocation strategy based on one's goals and risk tolerance. It is also important to recognize that macro conditions change over time. To ensure the portfolio maintains the desired risk and return profile, we encourage investors to revisit, review, and rebalance holdings periodically to adjust for portfolio drift and fluctuation in market conditions.
An index is unmanaged and not available for direct investment.
Moderate Growth and Income: 2% Bloomberg U.S. Treasury Bills (1–3 Month) Index, 30% Bloomberg U.S. Aggregate Bond Index, 6% Bloomberg U.S. Corporate High Yield Bond Index, 5% J.P. Morgan EMBI Global, 27% S&P 500 Index, 10% Russell Midcap Index, 3% Russell 2000 Index, 8% MSCI EAFE Index, 5% MSCI Emerging Markets Index, 4% Bloomberg Commodity Index.
Moderate Growth is composed of 2% Bloomberg U.S. Treasury Bills (1–3 Month) Index, 8% Bloomberg U.S. Aggregate Bond Index, 3% Bloomberg U.S. Corporate High Yield Bond Index, 35% S&P 500 Index, 14% Russell Midcap Index, 6% Russell 2000 Index, 15% MSCI EAFE Index, 12% MSCI Emerging Markets Index, 5% Bloomberg Commodity Index. U.S. Investment Grade Fixed Income encompasses the allocations to Short Term, Intermediate Term, and Long Term.
Moderate Income is composed of 2% Bloomberg U.S. Treasury Bills (1–3 Month) Index, 60% Bloomberg U.S. Aggregate Bond Index, 4% Bloomberg U.S. Corporate High Yield Bond Index, 5% JPM EMBI Global, 18% S&P 500 Index, 5% Russell Midcap Index, 4% MSCI EAFE Index, 2% Bloomberg Commodity Index. U.S. Investment Grade Fixed Income encompasses the allocations to Short Term, Intermediate Term, and Long Term.
Cash Alternatives. Bloomberg 1–3 Month U.S. Treasury Bill Index includes all publicly issued zero-coupon U.S. Treasury bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. In addition, the securities must be denominated in U.S. dollars and must be fixed rate and non-convertible.
Commodities. Bloomberg Commodity Index is a broadly diversified index of commodity futures on 20 physical commodities, subdivided into energy, U.S. agriculture, livestock, precious metals, and industrial metals sectors. Commodity weights are derived in a manner that attempts to fairly represent the importance of a diversified group of commodities to the world economy.
Global Fixed Income. Bloomberg Multiverse Index provides a broad-based measure of the global fixed-income bond market. The index represents the union of the Global Aggregate Index and the Global High-Yield Index and captures investment grade and high yield securities in all eligible currencies.
Bloomberg U.S. Aggregate 10+ Year Bond Index is unmanaged and is composed of the Bloomberg U.S. Government/Credit Index and the Bloomberg U.S. Mortgage-Backed Securities Index and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 10 years or more.
Bloomberg U.S. Aggregate 1–3 Year Bond Index is unmanaged and is composed of the Bloomberg U.S. Government/Credit Index and the Bloomberg U.S. Mortgage-Backed Securities Index and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of one to three years.
U.S. Investment-Grade Fixed Income. Bloomberg U.S. Aggregate Bond Index is composed of the Bloomberg U.S. Government/Credit Index and the Bloomberg U.S. Mortgage-Backed Securities Index and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities.
High-Yield Fixed Income. Bloomberg U.S. Corporate High Yield Bond Index covers the U.S.-dollar-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB= or below. Included issues must have at least one year until final maturity.
Global Hedge Funds. HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database.
Developed-Market Ex-U.S. Fixed Income. JP Morgan Government Bond Index Global Ex U.S. Index (JPM GBI Global Ex-U.S.) is a total return, market-capitalization-weighted index, rebalanced monthly, consisting of the following countries: Australia, Germany, Spain, Belgium, Italy, Sweden, Canada, Japan, the United Kingdom, Denmark, the Netherlands, and France.
Emerging-Market Fixed Income. JPM EMBI Global Index is a U.S.-dollar-denominated, investible, market-capitalization-weighted index representing a broad universe of emerging market sovereign and quasi-sovereign debt. While products in the asset class have become more diverse, focusing on both local currency and corporate issuance, there is currently no widely accepted aggregate index reflecting the broader opportunity set available, although the asset class is evolving. By using the same index provider as the one used in the developed market bonds asset class, there is consistent categorization of countries among developed international bonds (ex. U.S.) and emerging market bonds.
Global Equities. MSCI All Country World Index (MSCI ACWI) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of 23 developed and 26 emerging markets.
Developed Market Ex-U.S. Equities. MSCI EAFE Index (Europe, Australasia, Far East) Index is a free-float-adjusted market-capitalization-weighted index designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.
Emerging-Market Equities. MSCI Emerging Markets Index is a free-float-adjusted market-capitalization-weighted index designed to measure equity market performance of emerging markets.
U.S. Small-Cap Equities. Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.
U.S. Mid-Cap Equities. Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000® Index, which represent approximately 25% of the total market capitalization of the Russell 1000 Index.
U.S. Large-Cap Equities. S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock’s weight in the index proportionate to its market value.
Capital market assumptions (CMAs): It is important to note that indexes have limitations because they have volatility and other material characteristics that may differ from those of an investor's portfolio. They are unmanaged and not available for direct investment. Hedge fund indexes have limitations that are typical of other widely used market indexes, but these indexes are also subject to survivorship bias and limited data. Keep in mind that the securities included in an investment portfolio may differ significantly from the holdings, weightings, and asset allocation of an index, and unlike an index, an investment portfolio is subject to fees, expenses, taxes, transaction costs, and other charges typically associated with an investment account. The performance and volatility of an individual portfolio may be materially different from the performance of an index and should not be relied upon as a measure of the performance a portfolio may achieve. CMA forecasts are not promises of actual returns or performance that may be realized. They are based on estimates and assumptions that may not occur. There is no guarantee any investment will be profitable and not sustain a loss. Investors should consider the limitations of CMA data as it is applied to their own portfolio.
All investing involve risks, including the possible loss of principal. There can be no assurance that any investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics, which should be evaluated carefully before making any investment decision. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. The risks associated with the representative asset classes discussed in this report include:
Asset allocation and diversification do not guarantee investment returns or eliminate risk of loss including in a declining market.
Commodities: The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or other factors affecting a particular industry or commodity.
Equity securities: Stocks are subject to market risk, which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. The prices of small/mid-company stocks are generally more volatile than large-company stocks. They often involve higher risks because smaller and midsize companies may lack the management expertise, financial resources, product diversification, and competitive strengths to endure adverse economic conditions.
Fixed income: Investments in fixed-income securities are subject to interest rate, credit/default, liquidity, inflation, and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in a decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and/or principal. This risk is heightened in lower-rated bonds. If sold prior to maturity, fixed-income securities are subject to market risk. All fixed-income investments may be worth less than their original cost upon redemption or maturity. High-yield fixed-income securities are considered speculative, involve greater risk of default, and tend to be more volatile than investment-grade fixed-income securities. U.S. government securities are backed by the full faith and credit of the federal government as to payment of principal and interest if held to maturity. Although free from credit risk, they are subject to interest rate risk.
Foreign/emerging/frontier markets: Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging and frontier markets.
Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.
The information in this report was prepared by Global Investment Strategy (GIS). Opinions represent GIS' opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. Past performance is no guarantee of future results.
The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability or best interest analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. The material contained herein has been prepared from sources and data we believe to be reliable but we make no guarantee to its accuracy or completeness.
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