Understanding Asset Allocation and its Potential Benefits
- 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 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.
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
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.
Disclosures
A word about risk: All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Diversification does not ensure against loss. Asset allocation is the process of distributing investments among various classes of investments (e.g., stocks and bonds). It does not guarantee future results, ensure a profit or protect against loss. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy.
The portfolio structure is a representation of a sample portfolio and no guarantee is being made that the structure of the portfolio will remain the same or that similar returns will be achieved.
Hypothetical illustrations have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve results similar to those shown. In fact there are frequently sharp differences between hypothetical results and actual results subsequently achieved by any particular trading program.
One of the limitations of hypothetical results is that they are generally prepared with the benefit of hindsight. In additional, hypothetical scenarios do not involve financial risk, and no hypothetical illustration can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation if any specific trading program which cannot be fully accounted for in the preparation of a hypothetical illustration and all of which can adversely affect actual results.
PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world.
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