Defining how a portfolio of assets should be composed is the critical first step toward pursuing investment success. More than 90% of a portfolio’s return and risk are determined by the Asset Allocation (Vanguard, DFA). Of course the selection of specific investment instruments are important as well, but only once the fundamental structure of a portfolio has been defined, i.e. how much to allocate to specific asset classes.
In recent years, continued declines in interest rates have led to sizeable returns in most developed bond markets. This trend has resulted in today’s market environment of historically low or even negative interest rates. Absent a severe economic downturn or deflation, both of which seem quite unlikely to us in the coming year, the returns in traditional high quality bonds are likely to be very low. This forces investors to look for alternative sources of return. But where to invest is a challenge, not least because interventions by central banks in recent years have affected not just the yields and prices of bonds but also those of other asset classes, as well as the relationship (higher correlation) between the returns of various asset classes.
Our five-year forward-looking capital market assumptions represent our best estimates of returns and risks for the major asset classes, providing the cornerstone on which to build a robust diversified multi-asset
portfolio. One of the key forecasts is that equity returns compare favorably to both bonds and cash. Emerging market stocks are expected to outperform their developed market counterparts on the back of better margins and more attractive valuations.
Based on expected risks and returns, we continue to believe that bond allocations should be invested largely in short-term investment grade corporate bonds. We do not think that core government bonds should be
completely eliminated from a strategic fixed income allocation due to their role in stabilizing portfolios in case of unforeseen risk events.
Favoring the home market is a common and understandable behavior of investors. Home assets therefore represent an important building block in all our portfolios. But, investing predominantly or exclusively in home assets may introduce an unwanted sector bias in a portfolio. Moreover, a portfolio may become too exposed to specific economic and monetary cycles. In contrast, investing globally reduces exposure to individual country risks while providing a broader range of opportunities. This was again demonstrated in 2016, and our forecast of equity returns for the coming years continues to suggest that investing globally in equities offers useful diversification benefits. The inclusion of emerging market equities should be of particular interest in 2017 and beyond.