Why asset allocation matters

A previous report in the Why asset allocation matters series titled “The value of capital market assumptions” discussed the importance of the developing the strategic capital market assumptions (CMAs), how the CMAs have performed compared to our expectations, and how they are important for developing our strategic asset allocation guidance. In this report, we evaluated our expected performance statistics forecasts (return, risk, and risk-adjusted return) for three strategic asset allocations — Moderate Income (MI), Moderate Growth and Income (MGI), and Moderate Growth (MG) — by comparing them to realized performance statistics from January 1, 2010, through December 31, 2024.¹ The expectations are based on our CMAs that we formulated each year over the period. The strategic CMAs are designed in an effort to estimate performance over multiple market cycles and do not represent the anticipated return or risk performance of any particular year. In terms of macroeconomic conditions, most of the 15-year time frame we examined was expansionary and was coupled with historically low volatility in equities.

Our overall assessment of the average expected performance compared to the annualized 15-year performance for the allocations over this period can be summarized as follows:

• Our forecasted average expected returns (Chart 1) for the three allocations were largely aligned with the longer-term (15-year) annualized index-based returns. The equity-oriented mixes (MGI and MG) modestly exceeded our expected estimates as U.S. equities performed better than we had anticipated over the 15-year period. These allocations benefited from U.S. equity outperformance due to the strategic overweight to U.S. Large Cap Equities compared to the global benchmark. Meanwhile, the MI allocation’s performance fell short of our estimations as many fixed-income indexes suffered their worst one-year performance ever in 2022.
• Our forecasted average expected risk (measured by standard deviation, Chart 2) over the period was closely aligned with the 15-year annualized standard deviation as the record-long 2009 – 2020 bull market led to historically low volatility for most of the period, but higher volatility has persisted since.
• Our forecasted average risk-adjusted performance (measured by the Sharpe ratio², Chart 3) over the 15-year period for the allocations generally exceeded our estimates, which means that return per unit of risk was higher than we forecast. The 15-year annualized risk-adjusted return for the more conservative MI allocation exceeded the expected average (0.65 versus 0.51), largely due to an extended stretch of low interest rates and nominal fixed-income market volatility for most of the period. Low volatility and U.S. equity outperformance enhanced the risk-adjusted performance of the MGI and MG allocations over the period.

¹ We analyzed the three moderate asset allocations because they reflect a moderate risk tolerance for each of the three allocation objectives provided by Wells Fargo Investment Institute: Income, Growth & Income, and Growth. In addition to allocations for those with a moderate risk tolerance, allocations for conservative and aggressive risk tolerances are also provided by WFII for each of the three objectives. The performance information for the remaining six asset allocations (Conservative Income, Aggressive Income, Conservative Growth & Income, Aggressive Growth & Income, Conservative Growth, and Aggressive Growth) not discussed in the report can be found in the Appendix table titled “Performance statistics for the nine strategic asset allocations.” Performance results for the strategic allocations are calculated using blended index returns. Results do not represent actual trading and the results achieved do not represent the experience of any individual investor. In addition, results do not reflect the impact of any fees, expenses, or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Past performance does not guarantee future results.

² The Sharpe ratio measures the additional return investors can expect for accepting additional risk.

Expected return and risk of our three blended allocations are not indicative of historical averages, but rather, they represent our estimates of likely average annual returns over the long term. After probing each of the three allocations at a more detailed level in terms of return, risk, and risk-adjusted performance, we would highlight the following observations for the 15-year period:

Return performance was as expected for Moderate Income and Moderate Growth & Income

The MI investment objective, the most conservative of the three diversified allocations we evaluated, comprises a blend of roughly 70% fixed income and cash and 30% spread across equities and commodities. As Chart 1 shows, the 15-year annualized return of the MI allocation closely matched the average of our forecasted expected returns over the same period (5.0% versus 5.3%). The MGI allocation, comprised of roughly 50% fixed income and cash and 50% spread across equities and commodities, had a return over the 15-year period that exceeded our average expected return (7.3% versus 6.8%), reflecting the outperformance of U.S. equities.

Chart 1: Realized versus expected return for our three blended investment objectivesSources: © Morningstar Direct, All Rights Reserved¹, and Wells Fargo Investment Institute. Data as of December 31, 2024. Forecasts are not guaranteed and are subject to change. See end of report for important disclosures.

Moderate Growth exhibited higher returns with greater risk

The most aggressive of the three allocations we analyzed, the MG investment objective, comprises a blend of roughly 10% fixed income and cash and 90% spread across equities and commodities. As Chart 1 shows, the realized annual average return for MG was higher than the expected average return we projected over the 15-year period (8.8% versus 7.8%). U.S. equities experienced a record-long bull market from March 2009 to February 2020. Because the period we examined contained much of that momentous surge, returns for U.S. Large Cap Equities outperformed, leading realized returns of allocations with greater equity exposure to be higher than projected. Chart 2 shows that annualized risk for the MG investment objective modestly exceeded our forecasted risk over the 15-year period, while the annualized risk for the MI and MGI allocations were closely aligned with our expectations.

Chart 2: Realized versus expected risk for blended investment objectivesSources: © Morningstar Direct, All Rights Reserved¹, and Wells Fargo Investment Institute. Data as of December 31, 2024. Forecasts are not guaranteed and are subject to change. See end of report for important disclosures.

All three allocations outperformed on risk-adjusted bases

Over the past 15 years, low short-term interest rates over much of the period led all three allocations to outperform our forecasted risk-adjusted returns. The realized return outperformance of MGI and MG versus our forecasts due to strong U.S. equities performance helped the risk-adjusted returns for those allocations to be more efficient than the bond-heavy MI. Additionally, because of their low correlation with stocks and bonds, including a modest allocation to commodities in a diversified portfolio may help reduce expected volatility without sacrificing longer-term return. Our longer-term forecast is that the return per unit of risk would be higher for the lower-risk allocations, with diminishing returns per until of risk as expected risk increases.

Chart 3: Risk-adjusted versus expected risk-adjusted performance for blended investment objectivesSources: © Morningstar Direct, All Rights Reserved¹, and Wells Fargo Investment Institute. Data as of December 31, 2024. Forecasts are not guaranteed and are subject to change. See end of report for important disclosures.

Our capital market assumptions reflect our expectations for long-term performance of the economy and markets. Evaluation of three of our strategic allocations representing a moderate risk tolerance for our three objectives (Income, Growth & Income, and Growth) for the 15-year time period shows that our strategic allocation performance projections were closely aligned with realized performance. So, while not every asset class returned exactly what was forecast over the period, as a collection of assets, the allocations performed remarkably in line with our expectations.

Wells Fargo Investment Institute remains committed to creating allocations using a disciplined approach that historically has accurately forecast the performance of risk and return. Providing these risk and return statistics may help investors plan which level of volatility risk is most appropriate for their circumstances and how much return they may reasonably expect for taking on that risk. We believe a well-diversified portfolio may offer less volatility with potential for attractive risk-adjusted returns. Investors with long-term time horizons may be able to weather periods of volatility better than short-term investors because markets have historically moved higher over a long-term strategic time frame.

We advise investors to select an asset allocation strategy deemed fit for their designated financial goals, time horizon, and ability and willingness to withstand market ebbs and flows. Our strategic allocations are based on capital market assumptions (CMAs) that reflect prospective trends over multiple market cycles.

As forward-looking estimates, CMAs are not guarantees of returns or risk. Rather, they are average annual estimates; actual performance for each calendar year will likely fluctuate around CMA estimations. As part of a comprehensive formulation process, we regularly review previous CMAs and consider factors to account for deviations from original estimates. This evaluation step helps to refine our CMA estimates going forward.

Performance results for the strategic allocations are for illustrative purposes only. Dynamic allocations change as needed with adjustments to the strategic allocations. Results do not represent actual trading and the results achieved do not represent the experience of any individual investor. In addition, results do not reflect the impact of any fees, expenses, or taxes applicable to an actual investment. The indexes reflect the historical performance of the represented assets and assume the reinvestment of dividends and other distributions. An index is unmanaged and not available for direct investment. Past performance does not guarantee future results. Different investments offer different levels of potential return and market risk. Please see below for the definitions and risks associated with the representative indexes.

Average of expected returns, risk, and Sharpe ratios from 2010-2024 are based on WFII’s strategic return and risk assumptions and strategic asset allocations from 2010 through 2024. Average of expected returns, risk, and Sharpe ratios from 2009-2023 are based on WFII’s strategic return and risk assumptions and strategic asset allocations from 2009 through 2023. For illustrative purposes. Forecasts are based on certain assumptions and on views of market and economic conditions which are subject to change. Strategic expected returns are forward-looking geometric return estimates from Wells Fargo Investment Institute of how asset classes and combinations of classes may respond during various market environments. Expected returns do not represent the returns that an investor should expect in any particular year. They are not designed to predict actual performance and may differ greatly from actual performance. There are no assurances that any estimates given will be achieved.

Capital market and asset class assumptions are estimates of how asset classes and combinations of classes may respond during various market environments. Expected returns represent our estimate of likely average returns over the next several market cycles. They do not represent the returns that an investor should expect in any particular year. Geometric return is the compounded annual return that would give the same result as a given series of annual returns based on those same assumptions. The return and risk assumptions are statistical averages that do not represent the experience of any individual investor or any specific time period. Standard deviation is a measure of volatility. It reflects the degree of variability surrounding the outcome of an investment decision; the higher the standard deviation, the greater the risk. The Sharpe ratio measures the additional amount of return that an investor could expect to receive for taking on additional risk.

CMA forecasts are not promises of actual returns or performance that may be realized. They are based on estimates and assumptions that may not occur.

The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized.

Conservative Income is composed of: 2% Bloomberg U.S. Treasury Bills (1–3 Month) Index, 76% Bloomberg U.S. Aggregate Bond Index, 3% Bloomberg U.S. Corporate High Yield Bond Index, 3% J.P. Morgan EMBI Global, 12% S&P 500 Index, 2% Russell Midcap Index, 2% Bloomberg Commodity Index.

Moderate Income Is composed of: 2% Bloomberg U.S. Treasury Bills (1–3 Month) Index, 60% Bloomberg U.S. Aggregate Bond Index, 4% Bloomberg U.S. Corporate High Yield Bond Index, 5% J.P. Morgan EMBI Global, 18% S&P 500 Index, 5% Russell Midcap Index, 4% MSCI EAFE Index, 2% Bloomberg Commodity Index.

Aggressive Income is composed of: 2% Bloomberg U.S. Treasury Bills (1–3 Month) Index, 47% Bloomberg U.S. Aggregate Bond Index, 6% Bloomberg U.S. Corporate High Yield Bond Index, 8% J.P. Morgan EMBI Global, 21% S&P 500 Index, 7% Russell Midcap Index, 7% MSCI EAFE Index, 2% Bloomberg Commodity Index.

Conservative Growth & Income is composed of: 2% Bloomberg U.S. Treasury Bills (1–3 Month) Index, 39% Bloomberg U.S. Aggregate Bond Index, 6% Bloomberg U.S. Corporate High Yield Bond Index, 5% J.P. Morgan EMBI Global, 23% S&P 500 Index, 8% Russell Midcap Index, 2% Russell 2000 Index, 7% MSCI EAFE Index, 4% MSCI Emerging Markets Index, 4% Bloomberg Commodity Index.

Moderate Growth & Income is composed of: 2% Bloomberg U.S. Treasury Bills (1–3 Month) Index, 30% Bloomberg U.S. Aggregate Bond Index, 6% Bloomberg U.S. Corporate High Yield Bond Index, 5% J.P. Morgan EMBI Global, 27% S&P 500 Index, 10% Russell Midcap Index, 3% Russell 2000 Index, 8% MSCI EAFE Index, 5% MSCI Emerging Markets Index, 4% Bloomberg Commodity Index.

Aggressive Growth & Income is composed of: 2% Bloomberg U.S. Treasury Bills (1–3 Month) Index, 20% Bloomberg U.S. Aggregate Bond Index, 7% Bloomberg U.S. Corporate High Yield Bond Index, 6% J.P. Morgan EMBI Global, 31% S&P 500 Index, 12% Russell Midcap Index, 3% Russell 2000 Index, 9% MSCI EAFE Index, 6% MSCI Emerging Markets Index, 4% Bloomberg Commodity Index.

Conservative Growth is composed of: 2% Bloomberg U.S. Treasury Bills (1–3 Month) Index, 16% Bloomberg U.S. Aggregate Bond Index, 3% Bloomberg U.S. Corporate High Yield Bond Index, 33% S&P 500 Index, 13% Russell Midcap Index, 5% Russell 2000 Index, 14% MSCI EAFE Index, 9% MSCI Emerging Markets Index, 5% Bloomberg Commodity Index.

Moderate Growth is composed of: 2% Bloomberg U.S. Treasury Bills (1–3 Month) Index, 8% Bloomberg U.S. Aggregate Bond Index, 3% Bloomberg U.S. Corporate High Yield Bond Index, 35% S&P 500 Index, 14% Russell Midcap Index, 6% Russell 2000 Index, 15% MSCI EAFE Index, 12% MSCI Emerging Markets Index, 5% Bloomberg Commodity Index.

Aggressive Growth is composed of: 2% Bloomberg U.S. Treasury Bills (1–3 Month) Index, 37% S&P 500 Index, 16% Russell Midcap Index, 7% Russell 2000 Index, 18% MSCI EAFE Index, 15% MSCI Emerging Markets Index, 5% Bloomberg Commodity Index.

Bloomberg U.S. Aggregate Bond Index is a broad-based measure of the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market.

Bloomberg U.S. Corporate High Yield Bond Index covers the U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB= or below. Included issues must have at least one year until final maturity.

Bloomberg U.S. Treasury Bills (1–3 Month) Index is representative of money markets.

Bloomberg Commodity Index is comprised of 23 exchange-traded futures on physical commodities weighted to account for economic significance and market liquidity.

J.P. Morgan Emerging Market Bond Index (EMBI) Global is a U.S. dollar-denominated, investible, market cap-weighted index representing a broad universe of emerging market sovereign and quasi-sovereign debt. While products in the asset class have become more diverse, focusing on both local currency and corporate issuance, there is currently no widely accepted aggregate index reflecting the broader opportunity set available, although the asset class is evolving. By using the same index provider as the one used in the developed-market bonds asset class, there is consistent categorization of countries among developed international bonds (ex. U.S.) and emerging market bonds.

MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. Russell 3000® Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.

Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 25% of the total market capitalization of the Russell 1000® Index. Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.

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Bonds: Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Because bond prices generally fall as interest rates rise, the current low-interest-rate environment can increase the bond’s interest rate risk. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.

Cash Alternatives: Cash alternatives typically offer lower rates of return than longer-term equity or fixed-income securities and may not keep pace with inflation over extended periods of time.

Commodities: Investing in commodities is not appropriate for all investors. Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks.

Foreign: Foreign investing involves risks not typically associated with U.S. investing, including currency fluctuations, political instability, uncertain economic conditions, and different accounting standards. These risks are heightened in emerging markets.

Stocks: Stocks are subject to market risk which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. The prices of small/mid-company stocks are generally more volatile than large company stocks. They often involve higher risks because of smaller and mid-sized companies may lack the management expertise, financial resources, product diversification and competitive strengths to endure adverse economic conditions.

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The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability or best interest analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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