Are There Unintended Risks in Your Capital Market Assumptions?

Are There Unintended Risks in Your Capital Market Assumptions?

Executive Summary

For many investment professionals, the standard building-block approach to portfolio construction may introduce unintended problems. This traditional method—which uses capital market assumptions (CMAs) to forecast returns and risks before determining asset allocation—often leads to uncertain assumptions, unused inputs, and unconvincing portfolio results.

The conventional process starts by defining expected returns, volatilities, and correlations for various asset classes. These are then fed into a mean-variance optimization to calculate asset weights. However, this workflow has flaws. Return assumptions, like the equity risk premium, are highly uncertain. Asset allocators may find that the resulting portfolios don’t pass the reasonableness test, which leads them to tweak the assumptions until they find a sensible answer.  Portfolio managers don’t like the results of such long-term forecasts because they operate on a shorter horizon.

A more robust alternative is a risk-based framework that reverses the traditional workflow. Instead of letting CMAs dictate allocations, our approach starts with assigning a risk budget to each asset class. From these risk budgets, capital weights are calculated, and only then are the implied returns determined as a final reality check. This method is designed to construct portfolios that are sensible and practical from the start.

Our risk budgets are informed by our GRAIL (growth, rates, alpha, inflation, and loss mitigation) framework. GRAIL recognizes that asset classes are combinations of risk exposures to macroeconomic drivers of return—growth, rates, and inflation. This understanding helps us build more genuinely diversified and resilient portfolios. For example, while equities and credit are both driven by growth, government bonds are driven by rates, and commodities by inflation.

Connecting risk assumptions directly with allocations helps us create a more consistent and reliable foundation for constructing portfolios. This robust yet flexible framework can then adapt to any investor's true objectives, whether that’s wealth preservation, income generation, or aggressive growth, leading to higher confidence asset allocations.

This marketing communication is for professional/institutional and qualified clients/investors only. Not for retail use. Recipients who do not wish to be treated as professional/institutional or qualified clients/investors should notify their Allspring contact immediately.

ALL-01022026-xajgbhdv