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Education

Understanding Asset Allocation and its Potential Benefits

What you will learn
  • The importance of asset allocation
  • The impact of globalization on asset allocation
  • How to manage asset allocation

What is asset allocation?

Asset allocation is the process of balancing risk and return in a portfolio by investing across different asset classes, which are investments often grouped together. The major asset classes include bonds, stocks and cash. Other asset classes include commodities, currencies, real estate, and alternatives.

Asset allocation matters for many investor to help them pursue their investment goals. It is likely to have a bigger impact on portfolio performance than individual investments, as explained below.

Maintaining a diversified portfolio can help investors prepare for shifts in the economy, providing potential to capture opportunities and minimize the risk of overconcentration.

Traditional asset allocation strategies seek to mitigate overall portfolio volatility by combining asset classes with low correlations to each other – that is, asset classes that don’t tend to move in the same direction at the same time.

For example, the correlation between U.S. stocks and bonds has been mostly negative for the past 15 years, as shown in the chart below.

Correlation Between U.S. Stocks and Bonds

The figure is a line graph showing the correlation between U.S. stocks and bonds from 1997 to 2023. The Y-axis shows the correlation range of negative one to positive one, with zero represented by a center horizon line in the middle of the Y-axis. The graph shows extreme fluctuations over the time period, resembling the path of a graph of an electrocardiogram. In recent years, from 2021 to about mid-2023, the correlation is relatively high, between 0.4 and 0.8. The latest nadir was in 2019, when correlation was around negative 0.9.
As of 31 December 2023. Source: PIMCO, Bloomberg Stocks represented by S&P 500 Index, Treasuries represented by Bloomberg U.S. Treasury Index. It is not possible to invest directly in an unmanaged index.

The portfolio examples below help illustrate the potential benefits of combining asset classes with low or negative correlations. The portfolio in scenario 1 is invested entirely in U.S. equities, while the portfolio in scenario 2 has a 70% allocation to equities and a 30% allocation to bonds. As shown in the average return and volatility (used as a measure of risk) data  below the pie charts, having more than one asset class with low or negative correlations to each other (equities and bonds) can help lower volatility while still achieving solid growth.

The figure features two pie charts showing the compositions of two different portfolios. On the left, shaded in blue, the pie chart shows an allocation of 100% equities. Underneath the chart, it’s noted that the average return is 11.17% per annum, with volatility over the same period of 14.86%. On the right, a pie chart features a portfolio with an allocation of 70% in equities, in blue, and 30% in bonds, in green. The average annual return is 8.8% with a volatility of 11.64%.

For Illustrative Purposes Only.

20-year data as of 31 December 2023. Equities represented by S&P 500 Index; Bonds represented by the Bloomberg U.S. Aggregate Index. Volatility measured by annualized standard deviation of returns.

It is not possible to invest directly in an unmanaged index.

What is the impact of globalization on correlation?

In today’s market, asset class correlations have become less stable than many investors realize. Long-term trends such as globalization have driven correlations higher.

In addition, correlations may increase during periods of market turbulence. As a result, seemingly distinct asset classes appear likely to behave more similarly than many investors expect.

This environment makes it more challenging to construct a truly diversified and resilient portfolio because assets that were previously unrelated can now represent exposure to the same risk factors.

How can investors implement asset allocation?

Professional investment managers help investors implement asset allocation using two methods – strategic asset allocation and tactical asset allocation. By using both in combination, the manager sets the long-term course for the portfolio and responds to short-term market drivers.

Strategic asset allocation, which provides the long-term focus for a portfolio, is based on three key factors: investment objectives, risk tolerance, and time horizon. Depending on the return targets and the level of risk that investors can tolerate, portfolios may be labeled as conservative, income and growth, growth, or high growth. Below are examples of hypothetical portfolios showing percentage of allocation targets for different asset classes.

Asset Allocation Portfolios

The figure shows five pie charts side by side, with each one representing a portfolio with varying asset allocations, with blue representing global equity, green depicting global fixed income, dark red showing alternatives, and royal blue representing cash. On the left, the first chart presents aggressive growth, with a 92% allocation to global equities, 5% to fixed income, 2% to cash, and 1% to alternatives. Moving right to more conservative portfolios, the biggest changes amount to the proportions of equities and bonds. For a growth portfolio, the allocation is 77% in equities, 19% in bonds, 2% in cash and 2% in alternatives. Further to the right, the moderate growth portfolio and income and growth portfolios show decreasing allocations to equities and increasing ones to bonds. On the far right, the conservative portfolio shows an allocation of 17% to equities, 76% to bonds, 5% to alternatives, and 2% to cash.

For Illustrative Purposes Only.

Source: Morningstar Mutual Fund Portfolios Asset Allocation Series 2023. The target asset allocation shown is based off the most recent reallocation date of 20 November 2023. Asset classes shown are determined by Morningstar, Inc. Category groups. The asset allocation reflects asset class weightings of the target portfolio. The actual asset classes and asset allocation may differ, in some cases substantially, from the percentages shown above. Neither diversification nor asset allocation ensure a profit or guarantee against a loss. Those asset classes noted may be known to be a growth engine, income producer, or volatility dampener, but there is no guarantee this will hold true.

Given that markets constantly change, maintaining strategic asset allocation in a portfolio requires periodic rebalancing to maintain target allocations. In addition, an investor’s strategic asset allocation will likely change over time to reflect changing investment objectives, risk tolerance, and time horizons.

Tactical asset allocation, on the other hand, uses active management to increase or decrease exposure to a certain asset class based on macroeconomic fundamentals, valuations and market movements. Tactical asset allocation takes advantage of short-term opportunities, complementing the strategic asset allocation direction.

A well-diversified portfolio may also invest in different investments within each asset class. For example, the equity allocation in a portfolio may include domestic and international equities across a number of sub-sectors within those markets. 

Download 5 Things You Need to Know About: Asset Allocation for more information.

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