Asset Allocation: Recalibrating Risk

The Evolving Landscape  

In today’s market environment, effective asset allocation requires a discerning view of risk and return. For investors seeking to balance portfolio risk while positioning for future returns, understanding the relative value of equities and credit is critical. While equities have historically provided higher long-term returns, current valuations suggest they may be stretched. Owning too much equity at an inopportune time can have negative ramifications for a portfolio. Meanwhile, credit markets, despite spreads tightening to near all-time lows, present a unique, long-term opportunity for income generation, potential total return, and diversification away from equity risk.  

Equity Valuations: A Stretch Too Far? 

Equity valuations are often seen as a key driver of long-term returns, but they also come with heightened risk, particularly in a market where prices have been driven to historically high levels. As of early 2025, the S&P 500 Shiller CAPE Ratio is above its historical average, signaling stretched valuations that can increase downside potential. While the U.S. stock market has benefitted from strong corporate earnings and robust economic growth in recent years, the risk-reward dynamic is less favorable for equity investors at these levels. As interest rates remain higher than the past decade’s lows, the cost of capital for equities has increased, making it harder for companies to generate outsized returns. A correction in equity prices, or a prolonged period of volatility, is a realistic risk in this environment.  

Equities undeniably play a crucial role in any portfolio, but for investors looking to minimize overall risk, they represent a significant source of volatility. Actively managing equity exposure can help navigate this uncertainty. More importantly, adjusting equity allocations in response to changing market conditions allows investors to better control risk while still benefiting from the other assets within their portfolio.   

The chart below compares the annualized volatility between the S&P 500, representing U.S. stocks, and the U.S. Corporate High Yield index, which serves as a proxy for below-investment-grade credit markets. This comparison underscores the fact that equity volatility tends to be higher than that of high yield bonds over the long term. Investors can use this information alongside other analyses to make informed asset allocation decisions for their clients.  

Credit Exposure: A Buffer for Volatility 

Credit markets, despite some tightening of spreads, offer a compelling opportunity for investors looking to moderate portfolio risk. While spreads remain tighter than historical averages, they continue to provide attractive yield opportunities across a variety of credit sectors, making credit an appealing choice for income-seeking investors. Still, it’s important to note credit is also vulnerable to economic downturns and downside risk.  

Beyond income generation, credit exposure plays a key role in risk management within a diversified portfolio. It can act as a buffer, absorbing market shocks and reducing downside risk, particularly during periods of equity market volatility. While equities and credit may face significant declines in times of uncertainty, credit markets tend to be less volatile, allowing investors to diversify their sources of return and minimize overall portfolio risk. The chart below illustrates the relative market drawdowns between the S&P 500 and the Bloomberg U.S. Corporate High Yield index. 

Although tight credit spreads suggest a relatively low-risk environment, the relative value of credit compared to equities remains attractive from a risk-adjusted standpoint. With yields ranging from mid-single digits to low double digits, credit allows investors to capture near-equity-like returns over the long term, without exposing themselves to the same level of risk. Additionally, credit may provide better downside protection during equity downturns, making it a crucial component of a well-balanced portfolio that mitigates equity risks while enhancing portfolio efficiency. 

Managing Risk and Preparing for Opportunity 

Successful asset allocation requires a strategy that adapts to changing market conditions. To manage risk effectively, investors must regularly adjust their allocations, balancing potential upside with sufficient downside protection. This approach positions portfolios to capitalize on opportunities while mitigating disruptions. Metrics such as volatility and drawdown are useful tools for assessing market risks. The charts above illustrate the relative risks between two asset classes and should not be interpreted as signaling a compelling investment opportunity between them. 

Historically, equities have been the primary driver of growth. However, with high equity valuations, credit may now offer more attractive risk-adjusted returns. Integrating credit into an asset allocation strategy alongside equities can optimize returns, enhance income, and reduce downside risk. Through active management, investors can leverage a broad range of equity and credit sub-asset classes to construct well-diversified portfolios that balance growth, income, and risk-adjusted returns, positioning them for success in any market environment.