Vanguard's President and Chief Investment Officer, Greg Davis, examines the role that asset classes play in a portfolio in today’s market environment…

After a period of relative market calm, market dynamics in the last few years have called into question the viability of traditional allocation models like 60% shares / 40% bonds and the conventional roles of asset classes. Cash delivered record returns, bonds fell in tandem with shares in 2022, and U.S. equities continue to outpace equities in other developed markets. The speed at which the landscape changed, as central banks attacked inflation with higher interest rates, serves as a strong reminder of why investors need to resist the temptation to chase performance and why portfolio diversification remains as important as ever.

Equities

U.S. equities have contributed to much of the overall market performance since the global financial crisis in 2008–2009, but the drivers of that outperformance over the last decade have likely sown the seeds for more muted performance over the coming one. With stretched valuations and a slowdown in earnings growth, we’re forecasting annualised returns of 3.8%–5.8% in the U.S. equity market over the next decade. Investors should be cautious with U.S. equities, considering the expensive valuations and lower expected growth. By comparison, we anticipate returns of 6.9%–8.9% annualised over the next decade for international equities because of the multidimensional growth opportunities given lower volatility, cheaper valuations, and higher potential for growth.

Fixed income

Historically, bonds have served as a stabiliser for a portfolio because there’s usually less volatility risk in fixed income than in equities. Over the past decade or so, investors shied away from bonds in favour of cash and cash equivalents. But bonds and cash serve separate and distinct purposes. Over the long term, high-quality bond funds have tended to offer better diversification against stock volatility and higher yield potential than cash. While replacing bonds with cash may work in the short term, investors need to consider more than just yield if they want to design an all-weather portfolio.

Current economic conditions have made fixed income a more viable asset class that can grow over time and compound your returns for medium to long term savings needs. Global bond markets have repriced significantly over the last two years as interest rates increased, putting bond valuations close to fair. We expect global bonds to return a nominal annualised 3.9%–4.9% over the next decade. It’ll remain important to diversify because international bonds can mitigate overall volatility and improve portfolio outcomes through lower correlations.

Cash

Investors should think of cash as the tool to manage liquidity risk— it can be a strategic allocation for day-to-day needs, for emergency savings, or for those with a very low risk tolerance. Cash should not be considered a substitute for shares or bonds in any market environment, even in the current high interest rate environment, where investors have been able to get a real return on cash.

On the face of it, shifting your portfolio to cash seems like a good idea in this environment: There is no risk in cash and you’re getting the same return you might from bonds—for now. But cash is limited in its ability to keep up with inflation and investing in cash means forgoing risk premium. Investors must also consider the durability of the yield, which is anchored to monetary policy. If central banks cut interest rates, the yield on cash decreases, and you’ll miss out on the income you would have earned if you had maintained your target bond allocation.

The current economic and market environment is primed to tempt investors to consider forgoing their strategy in order to chase returns. But across and within asset classes, we can’t account for everything, such as how an AI-led productivity boom or geopolitical events could affect returns. Market leadership is not guaranteed, and chasing returns can leave investors exposed to unnecessary volatility and risk.

Our research shows that a balanced mix of diversified assets, combined with a disciplined, cost-conscious approach to investing, can help improve investors’ chances of achieving their long-term investment goals, as long as they stay the course.

Vanguard Australia