Asset allocation is probably the most important element in determining the potential success of an investment portfolio, but it may also be the hardest to adhere to in a rigorous way. Conceptually, investors are generally familiar with the idea that investments should be diversified across asset classes to spread risk. They may also have a vague notion about the behavioral differences among stocks, bonds and other categories that can offer insulation when one asset class is doing worse than another. However, beyond these general contours, the process of developing and maintaining an asset allocation is less understood, which we think is unfortunate because in our view effectively seeking the ultimate success of that asset allocation is reliant on the details—fashioning a portfolio structure consistent with individual goals, and following through to ensure that remains the case.

In our opinion, while an effective asset allocation is always important, this may be especially true in times of market difficulty, when that structure can help anchor investors to what they are trying to achieve over the long term, and limit the temptation to make abrupt changes that could undermine those goals. In a sense, the process of creating and maintaining an asset allocation is a bit like taking a long mountain climb, across a range of topographies and weather systems. Obstacles may emerge—storms, wild animals, rockslides—but the ability to course-correct and still maintain progress is what ultimately could make the difference. In this article, we review some key elements of the journey that asset allocation represents, and share our ideas on best practices.

Climbing the Asset Allocation ‘Mountain’

Source: Neuberger Berman. For illustrative purposes only.

Asset Allocation Has Largely Driven Portfolio Returns

Source: Vanguard, 2021. Calculations were based on monthly returns for 709 American funds from January 1990 to September 2015. Calculations were based on monthly net returns, and policy allocations were derived from a fund’s actual performance compared with a benchmark using returns-based style analysis (as developed by William F. Sharpe) on a 36-month rolling basis. Funds were selected from Morningstar’s Multi-Sector Balanced category. Only funds with at least 48 months of return history were considered in the analysis. The policy portfolio was assumed to have a U.S. expense ratio of 1.5 basis points per month (18 bps annually, or 0.18%). For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Indices are unmanaged and not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Create Your Investor Profile

There are no shortcuts to developing and maintaining a portfolio customized to fit unique personal goals. It generally requires considerable reflection and work with advisors.

Typically, the process begins with a focus on the investor, to develop a clear sense of available assets and the various necessities and aspirations that they anticipate in the future. We also want an idea of the investor’s risk capacity (the amount of risk they need and are able to take in pursuit of goals) and, a more psychological measure, their risk tolerance (or the risk they are willing to take in order to help meet those goals). The latter is often based on personality, values or general attitude toward risk.

Which Portfolio Would You Prefer?

Hypothetical downside/upside

Source: Neuberger Berman. For illustrative purposes only.

Depending on the existing asset level, investment timeframe and long-term “capital market assumptions” (return outlooks), the investor’s goals may prove to be very achievable, within range or unrealistic. However, even if achievable, they may not be appropriate if the investor cannot tolerate the corresponding risk exposure and is likely to want to sell at a poor time. A clear mountain pass may provide opportunity to save time, but may be the wrong choice if danger signals may cause the walker to retreat or progress too slowly.

Develop a Strategic Asset Allocation

With the investor’s goals in mind, we can estimate a target rate of return that can help achieve them, and then see, based on our firm’s capital market assumptions, a hypothetical of what this might look like in terms of associated portfolio risk and asset mix. Thinking about the mountain hike, your strategic asset allocation is like a trail map with your route and destination clearly marked.

Naturally, there are always tradeoffs. Equities generally carry extensive risk of near-term volatility. Bonds can balance risk, but typically offer less total return potential. Private equity or debt may offer a premium to public markets, but that comes with illiquidity risk. Cash may also have tactical use, and save assets in the near term, but when held over time tends to lose ground to inflation.

After some back and forth with an advisor, the investor can often settle on an asset allocation that occupies a middle ground—seeking to provide a combination of return potential and the ability to mitigate dangers that jibes with the investor’s unique makeup.

In light of the potential risk-mitigation benefits of diversification, the allocation may include core equity and bond holdings, diversifying assets within both areas, such as small-cap and international equities, or high yield bonds or preferred securities, and some exposure where appropriate to alternative assets such as private equity or hedged strategies. These “diversifiers” can play a valuable role in reducing volatility, enhancing yield, growing assets and/or reducing correlations across the portfolio. From there, the asset allocation can be implemented with specific investment strategies and managers potentially well suited to each category.

Deviations Through ‘Tactical Tilts’

Although the overall direction of the portfolio may be determined by your “map,” the details and specific route may vary, depending upon what is encountered along the way. Where feasible, shorter-term tactical “tilts” from your strategic allocation may be appropriate to, for example, help minimize the impact of market volatility or capitalize on lower valuations in particular asset classes. In other words, you may have more than a few opportunities to reshape your portfolio in light of changing circumstances.

In the current environment, we believe that investors should generally try to limit overall sensitivity to equity market risk, which may involve emphasizing securities that tend to be relatively insulated from broad economic and market fluctuations, and more dependent on individual business dynamics. Writ large, this may mean favoring value over growth shares, and looking to equity income given the relative durability of dividend payouts that it could provide. Taking inflation into account may also be important, by looking to fixed income with less sensitivity to interest rate risk, and assets that may be more correlated to higher prices, such as real estate and commodities. Finally, exposure to private markets may offer differentiated return opportunities that are less sensitive to short-term market disruption.

Overall, your ultimate goal of reaching the summit remains the same. However, the route you take to navigate past unexpected obstacles may be adjusted to reach the top safely and efficiently.

Market Volatility Has Intensified

S&P 500: Trading days > 1% move

Source: Bloomberg, as of August 31, 2022. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Indices are unmanaged and not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Investment Themes for Volatile Times

Implementing Your Allocation

Although we believe asset allocation is the cornerstone of an effective portfolio, populating that allocation with appropriate strategies is also crucial. Here at NB Private Wealth, the Private Wealth Investment Group leverages broad expertise to help develop investment solutions for U.S.-based private wealth clients. Private Wealth Investment Group works closely with wealth advisors, portfolio managers and clients with the goal of designing and implementing customized and diversified investment plans. By tapping into the extensive investment capabilities across the firm, including capital markets assumptions, asset allocation and Environmental, Social and Governance disciplines, Private Wealth Investment Group incorporates our best thinking across both public and private markets to construct tax-efficient, multi-asset class portfolios.

Monitor and Adjust

A key, in our view, is to revisit your overall investment framework on a regular basis in light of your goals. Wealth planning is not a static process, but a dynamic one. Market conditions may change, and so may your priorities, lifestyle or family circumstances, including unforeseen health events or the need for long-term care. If, based on a periodic review, you appear to be running behind where you should be, that may require shifts in allocation, or perhaps more focus (for those still in the earning years) on saving. On the other hand, if you find that you have more than you may need, you can take the opportunity to dial back on risk exposures.

It is crucial that adjustments to portfolios take place in a measured, incremental way that takes into account market realities, but keeps in mind long-term trends. Investors have often panicked in very difficult periods, pulling back on market exposures at the wrong time—and essentially stopping progress completely. This can be detrimental, as market recoveries often take place in short spurts, often when investor pessimism is at its worst. The fallout from such “untimely” market timing is evident from looking at a hypothetical portfolio that has missed strong days in the market.

Sticking to an Asset Allocation Is Important

Missing Best Days Has Hurt Performance: Hypothetical Growth of $10 Million Over the Last 10 Years

Source: Bloomberg as of June 30, 2022. IMPORTANT: The performance and risk projections/estimates are hypothetical in nature and are based on the assumptions set forth herein. The estimates do not reflect actual investment results and are not guarantees of future results. Results are gross of fees and do not reflect the fees and expenses associated with managing a portfolio. If such fees and expenses were reflected, results shown would be lower. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Keeping on the Path

In the end, we believe your asset allocation should be a reflection of you and what you wish to achieve in life. One of the ways that investment goals and allocations can go wrong is when a person deviates from long-term strategy, whether taking on too much risk in a strong environment or “turning back” at an inopportune point in a market decline. We believe the current environment is testing the resolve of many investors; and given concerns about economic and market dynamics, it is likely an appropriate time to reassess exposures and the immediate path forward. What can make that analysis more meaningful is a true understanding of your goals and destination, and where your portfolio is on the “map” in relation to achieving them. Such knowledge can help you make intelligent decisions to press forward and have more confidence in difficult times on your financial journey.