Tactical choices in portfolio construction may induce sub-optimal results. Even if one were able to predict future economic developments perfectly, it remains a challenge to take advantage of them. If tactical choices aren’t the key to investment success, what is?

An overarching issue is the strategic allocation across different asset classes. This focuses on the long term: does an investor mainly invest in stocks, bonds, or alternative investments? And what are optimal proportions to do so?

Two primary principles for drawing up a strategic allocation are that (i) diversification across different asset classes ensures risk diversification; (ii) risk-bearing capital should decrease with age. Applied to stocks and bonds, the theory leads to the advice to allocate to both investments, shifting the center of gravity from shares to bonds over time. This theory is taught in financial textbooks, forms the basis for standard investment profiles of pension funds, and investment funds have even been set up that apply the theory as a standard, so-called target date funds.

Recent research places a critical note, arguing that a portfolio consisting of 100% equities leads to better long-term outcomes than diversified alternatives. The finding holds even during scenarios(1)  where equities perform poorly (see chart below).

One possible reason why their conclusion contradicts the consensus lies in the design of the study. The authors had access to detailed data from all developed countries, whereas other research often focuses solely on the US. Additionally, the simulation technique was better able to replicate the long-term trends in capital markets.

Another important finding is that bonds are more correlated to equities than would appear based on monthly returns. Bonds therefore offer less protection for adverse stock market scenarios than is often assumed. Moreover, bonds have a lower return potential and are susceptible to inflationary shocks. The research contrasts strongly with traditional life-cycle theory and is therefore (potentially) very relevant for investors.

Bluemetric Insight | The optimal allocation of assets is a complex and dynamic issue for every investor. Despite empirical evidence that fully allocating to equities would lead to optimal results, it is not advisable to adopt this advice without caution. In addition to numerical considerations, inves-tors should incorporate behavioral aspects of their investments. A portfolio consisting of only stocks may imply the ‘best’ result but will experience greater price fluctuations along the way. To implement such a strategy, investors need to determine whether they can withstand this heightened volatility.