In equities, strong earnings growth from the Magnificent 7 over the past three years has exacerbated an already powerful period of growth outperformance, leaving investors underweight other markets.
Over the course of many years, “correct” portfolio construction (think a diversified portfolio, with exposure across stocks and bonds, both domestically and abroad) has slowly become unpopular. This is because certain assets have consistently outperformed their counterparts: stocks over bonds, growth over value and U.S. over international. As a result, at the beginning of 2025, many investors may have found themselves “offsides,” as bonds rallied and ex-U.S. equity markets surged. They won’t want to be “offsides” again.
When thinking about how to get back “onsides” with portfolio construction in 2026, investors must ask themselves a series of outcome-oriented questions: Are they looking for income, capital preservation or growth? Along the way, are they tolerant of volatility or risk-averse? And is liquidity a concern? The answers to those questions inform allocation decisions, and both traditional and alternative assets play a role.
How these assets will perform is tied to the macro backdrop. Here, the picture is as muddled as ever: Growth is cooling but not cold, with a low unemployment rate obscuring a meaningful slowdown in job creation and consumption progressing unevenly between the wealthiest and the less fortunate; inflation is trending in the wrong direction for now, but should fall later in 2026; and significant policy changes are underfoot. All of this translates into oscillating interest rate expectations across the curve, which means volatility in markets.
Beneath this volatility, the opportunity set has shifted. Fixed income is arguably more attractive than in recent decades. However, while allocations to intermediate bonds have increased to 12-month highs, 80% of investors remain underweight duration relative to the Bloomberg U.S. Aggregate. That shouldn’t be a problem, though, as a steepening yield curve suggests most of any upcoming decline in interest rates will occur at the shorter end. That said, investor sentiment will ultimately inform the appropriate exposure: concerns around growth would suggest an extension in duration, for example, as the current rate environment makes bonds an effective ballast against recession. The credit conversation follows a similar path: while a benign macro backdrop supports a greater allocation to credit, recession fears would encourage an emphasis on active management.
In equities, strong earnings growth from the Magnificent 7 over the past three years has extended an already powerful period of growth outperformance, leaving investors underweight other markets. While U.S. equity portfolios seem to have equal exposure to value and growth when approached at the index level, an analysis of underlying holdings shows an overweight to growth. In addition, interest in foreign markets has come off a boil after surging earlier this year on the backdrop of impressive performance. Over the course of the year, the average allocation to ex-U.S. stocks has risen from 20% to 25% of all equity holdings – a meaningful increase but still well below what is considered “diversified.”
These underweights are too severe: structural shifts in foreign markets, which have led to improved fundamentals this year, should persist, allowing them to continue to compete. Moreover, while the breadth of U.S. equity market performance hasn’t improved as much as initially expected, it is trending in the right direction: the Magnificent 7 have accounted for less of 2025’s S&P 500 performance than in previous years and earnings growth continues to broaden out, with analysts predicting near-parity between the Magnificent 7 and the rest of the index. This suggests that with overall valuations at multidecade highs, select value sectors should play a bigger role in 2026, though growth should continue to fare well as the long-term secular force of AI continues to mature. In other words, portfolios should be balanced.
For alternatives, the outcome-oriented approach toward portfolio construction is particularly relevant. Each major sub-asset class is set to play a specific role: stretched valuations in public equities will challenge future returns, income opportunities are fading as rates fall and stock/bond correlations should remain positive in the absence of a recession. These assets will also become increasingly accessible for average investors, as regulation shifts and technology “democratizes” access through lower minimums and greater liquidity. For this reason, the traditional stock/bond framework of “60/40” should be reformed into one that also includes alternative assets: a “60/40+”, for example, where, depending on the desired outcome, alternative assets are folded in to complement public market holdings, should result in stronger, less correlated returns with reduced volatility.
All told, while traditionally diversified portfolios may not be as popular as before, a broader evolved model of diversification is more critical than ever. Unfortunately, that rebalancing has a cost: taxes. For this reason, investors should incorporate tax management into portfolio construction in 2026, with an emphasis on ETFs for their tax-efficiency and “tax loss harvesting” to improve after-tax outcomes.
For those worried that in today’s world diversification is dead, take comfort: reports of its death are greatly exaggerated, and now marks an excellent time to get back “onsides.”