Asset allocation: Reports of my death are greatly exaggerated

The notion of “correct” portfolio construction has been challenged and diversification has become unpopular. This is because certain assets have outperformed their counterparts: stocks over bonds, growth over value and U.S. over “international.” As a result, many investors may find themselves “offsides,” over-allocated to past winners and underweight laggards.

When thinking about portfolio construction in 2025, investors must determine what problems they are solving for: are they looking for income, capital preservation or growth? Are they tolerant of volatility or risk-averse? And is liquidity important? The answers to those questions will inform asset allocation, and both traditional and alternative assets can play a role.

How these assets will perform is tied to the macro backdrop. Here, the picture is muddled: growth remains robust on the back of strong consumption and a tight labor market; core inflation is still somewhat firm; and the outcome of the U.S. election suggests significant policy changes might be in the pipeline. All of this means that the interest rate outlook may oscillate, translating into volatility across the economy and markets.

Underneath this volatility, the opportunity set is shifting. Fixed income is arguably more attractive than in recent decades, though while allocations to intermediate bonds have increased, many investors remain underweight duration relative to the Bloomberg U.S. Aggregate. That said, those changing rate expectations suggest duration should not be overextended, and ultimately investor sentiment should inform the appropriate exposure: those concerned about the economy should extend more – current rates make bonds an effective ballast against recession – and those interested in income extend less. The credit conversation follows a similar path: while a benign macro backdrop supports an overweight to credit, especially for total return seekers, recession fears would encourage a tightening-up on credit quality.

In equities, strong earnings growth from the “Magnificent 7” over the past two years has exacerbated 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 a 10%pt overweight to growth. Interest in foreign markets seems to have stalled, with the average allocation to ex-U.S. equities at a 12-month low. This translates into a 20% average allocation within equity portfolios to international assets, roughly half of what is considered “diversified.”

These underweights are too severe: geopolitical uncertainty, currency headwinds and widening growth differentials could make strong and sustained foreign market performance illusive, though multiple expansion and improvements to earnings growth, coupled with a focus on long-term trends, should allow ex-U.S. markets to compete. Moreover, with inflation easing and borrowing costs falling, U.S. earnings growth should broaden out and will likely include value names, which as an added benefit are also attractive to income- seeking investors, especially as bond yields continue to normalize. That said, the pendulum should not swing too far: large cap U.S. growth names, including the “Magnificent 7,” still have strong secular tailwinds behind them. In other words, portfolios should be balanced.

For alternatives, the outcome-oriented approach toward portfolio construction is particularly relevant, with each major component – commodities, hedge funds, real assets and private capital – solving for one or more “problems.” This will be particularly true looking forward, with stretched valuations challenging future returns, income opportunities fading as rates fall and stock/ bond correlations remaining positive in the absence of a recession, and will complement cyclical, structural tailwinds for the asset class like a normalizing rate environment. These assets will also become increasingly approachable, as technology “democratizes” access through lower minimum investments and greater liquidity. For this reason, the traditional stock/bond framework of “60/40” may be reformed into one that also includes alternative assets: a “50/30/20” portfolio, for example, with the 20% allocation to alternatives financed to varying degrees by both stocks and bonds.

All told, while the “60/40” portfolio may not be as relevant as it once was, this is because it has evolved, not because diversification is unnecessary. In fact, as macro forces continue to shift and a bevy of potential policy changes loom on the horizon, a well-diversified long-term portfolio will be that much more important, helping to keep investors steady through turbulence and prevent them from “jumping ship.” For those worried that in today’s world, the “60/40” is dead, take comfort: reports of its death are greatly exaggerated, and the “new” diversified portfolio is alive and kicking.

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