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Evaluating portfolio returns

Five issues for investors to consider.

An objective evaluation of investment returns requires understanding the mix of assets in a portfolio. This mix is an important component of establishing return expectations. For example, if the portfolio is composed mostly of high-quality bonds, we would expect, over time, lower returns (and lower volatility) than what we likely would experience investing in an all-equity portfolio.

In other words, investing in a mix of equities and fixed income, and perhaps other asset groups, alters the risk and return investors should expect from their portfolio. A healthy balance between a mix of asset classes can potentially reduce risk and increase expected return.

Question 1: Given that global equities have outperformed other asset classes during the recovery, should investors simplify their portfolio’s allocation?

Historically, domestic large-cap stocks have tended to outperform a globally diversified portfolio in periods of increased positive momentum in the U.S. economy relative to international economic conditions.

Different macroeconomic factors in the U.S. economy, such as gross domestic product (GDP) growth, low interest rates, central bank intervention, and healthy consumer sentiment have been positive influences for domestic large-cap equities in particular. However, the economic environment can change abruptly, likely affecting market conditions. Attempting to time market corrections to preserve the value of portfolios can be difficult.

Question 2: If investors have a long investment horizon, why not invest in the asset class that has had the highest return over time?

Over longer time periods, we have seen equities outperform fixed income and small-cap equities outperform large-cap equities. At times, international equities have outperformed domestic stocks.

Patterns of returns are largely unpredictable over shorter time periods, with some asset classes rising to the top of the group one year only to fall to the bottom the next. Many investors would be uncomfortable with the volatility that equities have experienced over the past 15 years, yet investing solely in this asset group would have yielded the highest returns (see chart on page 8 of full report).

For many investors, a middle-of-the-group performance, such as what we’ve seen with the globally diversified Moderate Growth and Income portfolio, may be a good option for balancing risk and return.

Performance results for the Moderate Growth and Income Four-Asset-Group (MGI 4AG) and 60% equities/40% fixed income portfolios are hypothetical and for illustrative purposes only. Hypothetical results do not represent actual trading, and the results achieved do not represent the experience of any individual investor. In addition, hypothetical 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. Hypothetical and past performance do not guarantee future results. See "Composition of portfolios" at the end of this document.

Question 3: How can investors assess their portfolio’s return?

An important step of successful investing is to work with an investment professional to monitor and evaluate the portfolio to make sure investors remain on track with their investment plan.

It’s easy to tell when one asset class performs better than another (for example, large-cap equities performed better than a diversified portfolio over several of the past few years), but by focusing only on return, we are not evaluating the portfolio on a risk-adjusted basis, nor are we taking the investor’s specific circumstances and constraints into consideration.

Investors may want to evaluate their portfolio from several perspectives. Bear in mind that none of these benchmarks are perfect. Each tells us different things about the portfolio. See the full report for a discussion of blended, simple, and goals-based benchmarks.

Question 4: What role does diversification play?

In economics, there is something called “opportunity cost,” which essentially means the value of the option that investors give up by choosing one alternative over another.

Say an investor chooses a diversified portfolio of stocks, bonds, real assets, and alternative investments. Over a particular investment horizon, the expected return of this mix of assets may be lower than that of certain single-asset classes, such as U.S. large-cap stocks. The opportunity cost of holding a diversified portfolio is the difference in expected return. The benefit is lower expected risk over time.

We believe a portfolio is well served when investors stay focused on achieving their investment goals and do not move into an asset simply because it has been a recent top performer.

Question 5: Why do globally diversified portfolios appear to be a good choice going forward?

Many investors look to their investment account statement to gauge how their portfolio performed. Most tell us they look at two things: what went up and what didn’t. They don’t like owning investments that performed poorly and often feel like they do not own enough of what performed well.

We believe it is important to construct a portfolio that has risk and return characteristics in harmony with personal circumstances and financial goals. Investment professionals can use our forward-looking capital market assumptions (CMAs), which are based on historical asset return and risk relationships, to help develop an appropriate investment portfolio mix.

Learn more about evaluating portfolio performance.

Asset-class risks

Asset allocation is an investment method used to help manage risk. It does not ensure a profit or protect against a loss. Diversification cannot eliminate the risk of fluctuating prices and uncertain returns. Diversification also does not guarantee profit or protect against loss in declining markets. Alternative investments carry specific investor qualifications which can include high income and net-worth requirements as well as relatively high investment minimums. They are complex investment vehicles which generally have high costs and substantial risks. The high expenses often associated with these investments must be offset by trading profits and other income. They tend to be more volatile than other types of investments and present an increased risk of investment loss. There may also be a lack of transparency as to the underlying assets. Other risks may apply as well, depending on the specific investment product. Commodities: The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or other factors affecting a particular industry or commodity. Equity Securities: 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. Fixed Income: Investments in fixed-income securities are subject to interest rate and credit 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. Credit risk is the risk that an issuer will default on payments of interest and principal. High yield fixed income securities are considered speculative, involve greater risk of default, and tend to be more volatile than investment grade fixed income securities. All fixed income investments may be worth less than their original cost upon redemption or maturity. U.S. government securities are backed by the full faith and credit of the federal government as to payment of principal and interest if held to maturity. Although free from credit risk, they are subject to interest rate risk. Foreign/Emerging Markets: Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets. Real Estate: Investing in real estate investment trusts (REITs) has special risks, including possible illiquidity of the underlying properties, credit risk, interest rate fluctuations, and the impact of varied economic conditions.

Composition of portfolios

Hypothetical Moderate Growth & Income Four Asset Group without Private Capital: 3% Bloomberg Barclays US Treasury Bill 1-3 Months, 22% Bloomberg Barclays US Aggregate Bond Index, 6% Bloomberg Barclays US Corporate High Yield Index, 5% JPM EMBI Global TR USD Index, 20% S&P 500 Index, 10% Russell Mid Cap TR USD Index, 8% Russell 2000 Index, 6% MSCI EAFE GR USD Index, 5% MSCI EM GR USD, 15% HFRI Fund Weighted Index.

Index definitions

An index is unmanaged and unavailable for direct investment. 

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

Bloomberg Barclays U.S. Corporate High-Yield Bond Index (Bloomberg Barclays U.S. Corporate High Yield) covers the universe of fixed-rate, noninvestment-grade debt.

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

Bloomberg Commodity Index is a broadly diversified index comprised of 22 exchange-traded futures on physical commodities and represents 20 commodities weighted to account for economic significance and market liquidity.

HFRI Fund Weighted Composite Index is a fund-weighted (equal-weighted) index designed to measure the total returns (net of fees) of the approximately 2,000 hedge funds that compose the index. Constituent funds must have either $50 million under management or a track record of greater than 12 months.

HFRI Indices have limitations (some of which are typical of other widely used indices). These limitations include survivorship bias (the returns of the indices may not be representative of all the hedge funds in the universe because of the tendency of lower performing funds to leave the index); heterogeneity (not all hedge funds are alike or comparable to one another, and the index may not accurately reflect the performance of a described style); and limited data (many hedge funds do not report to indices, and, therefore, the index may omit funds, the inclusion of which might significantly affect the performance shown. The HFRI Indices are based on information self-reported by hedge fund managers that decide on their own, at any time, whether or not they want to provide, or continue to provide, information to HFR Asset Management, LLC. Results for funds that go out of business are included in the index until the date that they cease operations. Therefore, these indices may not be complete or accurate representations of the hedge fund universe, and may be biased in several ways. Returns of the underlying hedge funds are net of fees and are denominated in U.S. dollars.

JP Morgan Global Ex United States Index (JPM GBI Global Ex-U.S.) is a total return, market capitalization weighted index, rebalanced monthly, consisting of the following countries: Australia, Germany, Spain, Belgium, Italy, Sweden, Canada, Japan, United Kingdom, Denmark, Netherlands, and France. 

JPM EMBI Global Index 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 Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is 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 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.

S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock’s weight in the index proportionate to its market value.

Wells Fargo Investment Institute, Inc. (WFII) is a registered investment adviser and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the Global Investment Strategy (GIS) division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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