• Elevated interest rates and high equity valuations mean bonds currently offer a more attractive risk reward ratio than usual.

• TVAA’s equity exposure remains diversified and less dependent on AI winners.

• Using valuation aware forecasts, TVAA adjusts allocations to seek steadier returns and lower volatility, while pursuing a smoother long-term return journey.

With today’s investment climate of high interest rates and elevated equity valuations, understanding how to allocate across asset classes is essential. To help portfolio constructors navigate this environment, we use our valuation aware, time varying asset allocation (TVAA) approach. TVAA is a systematic framework that adjusts allocations based on market conditions. One application of TVAA is the aim of earning higher risk-adjusted returns relative to a strategic benchmark, which can be appropriate for investors willing to take on active risk in the form of “model forecast risk”. It is not designed to predict the next market move, but to tap an additional source of potential outperformance over the medium term. The portfolio shown in this article is illustrative, designed to demonstrate such a TVAA portfolio given the current market backdrop. 

Balancing long term opportunity with near term discipline

Elevated interest rates combined with still high starting equity valuations point to a slimmer equity risk premium than many investors have grown used to. And while the market remains gripped by the promise of AI, history shows that major technology cycles often bring spurts of exuberance followed by slower, uneven payoffs. Against this backdrop, our valuation aware, TVAA approach resists the temptation to extrapolate today’s enthusiasm directly into tomorrow’s earnings. Instead, it aims to position portfolios for a range of outcomes, balancing long term opportunity with near term valuation discipline.

We cut equity exposure in our TVAA model by 20% relative to a 60/40 benchmark, holding 40% in equities and 60% in bonds. The portfolio is designed for investors willing to take model forecast risk in exchange for a more balanced path through an AI charged cycle¹.

Equities: participation without over reliance on the few

Within equities, we prefer breadth over concentration. The portfolio keeps a clear US anchor but expresses it through diversified building blocks: the US value factor (4.6% allocation), US growth factor (6.2%) and US small cap factor (5.2%)¹. Alongside that, the portfolio has an allocation to developed market ex US equity (12.0%) and a smaller holding in emerging market equity (2.0%). This reflects our view that AI related gains may spread beyond today’s headline winners and that the long term benefits of new technology tend to diffuse across regions and sectors rather than reward only the early champions. We want exposure to that broadening, not a bet on a single market or theme.

Fixed income: quality as a source of endurance

Economic transformations often come with sharp rotations in equity market leadership. High quality bonds can help investors stay the course through those shifts. With credit spreads still tight, we prefer to tilt away from explicit credit risk. Instead, we anchor the portfolio to US aggregate bonds (26.6%) and hedged non-US bonds (24.0%), complemented by US Treasuries across the curve (2.0% short term and 5.4% long term) and a small allocation to US intermediate-maturity credit (2.0%). This provides investors income, diversification and a cleaner ballast should equity optimism ebb.

A deliberate, active tilt with known trade offs

Our 10 year projections show a slightly higher expected return than the benchmark (5.7% versus 5.3% annualised) and meaningfully lower expected volatility (6.9% versus 9.3%). That comes with active risk: expected tracking error is around 3.89%, and the probability of underperforming the benchmark in any given year is approximately 45%.

The aim is simple: to balance near term macro momentum, long term valuation discipline and the lessons from past technology cycles. We want the portfolio to take part in the gains that disruptive innovation can bring while maintaining the resilience needed for the phases when sentiment outruns reality.

TVAA                                                                                                  Benchmark        

Portfolio characteristics²

Source: Vanguard analysis, January 2025.

Asset class return expectations

Equity return expectations: distribution of annualised expected returns over the next 10 years in US dollar terms.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Notes: The forecast corresponds to the distribution of 10,000 Vanguard Capital Markets Model (VCMM) simulations for 10-year annualised nominal returns in USD for assets highlighted here. Asset-class returns do not take into account management fees and expenses, nor do they reflect the effect of taxes. Returns do reflect the reinvestment of income and capital gains. Indices are unmanaged; therefore, direct investment is not possible. 

Source: Vanguard calculations as at 31 October 2025. 

IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modelled asset class. Simulations are as at 31 October 2025. Results from the model may vary with each use and over time.

Bond return expectations: distribution of annualised expected returns over the next 10 years in US dollar terms.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Notes: The forecast corresponds to the distribution of 10,000 VCMM simulations for 10-year annualised nominal returns in USD for assets highlighted here. Asset-class returns do not take into account management fees and expenses, nor do they reflect the effect of taxes. Returns do reflect the reinvestment of income and capital gains. Indices are unmanaged; therefore, direct investment is not possible. 

Sources: Vanguard calculations as at 31 October 2025. 

IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modelled asset class. Simulations are as at 31 October 2025. Results from the model may vary with each use and over time.

Overall, the portfolio positioning reflects a disciplined approach to today’s valuation landscape and market dynamics. Underlying these decisions is Vanguard’s proprietary valuation-aware time-varying asset allocation. TVAA is for investors who are comfortable with model forecast risk, which is a type of active risk. It can serve as a useful guide for professional asset allocators to dynamically adjust a portfolio’s positioning based on medium-term forecasts to enhance returns or manage risks, or both, depending on the market environment.

For an in-depth look at what Vanguard expects for the economy and markets in 2026, read AI exuberance: Economic upside, stock market downside.

¹ Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results. Capital at risk. Time‑varying portfolio allocations were determined by the Vanguard Asset Allocation Model (VAAM). Equity assets under consideration were US value factor, US growth factor, US small factor, developed markets ex‑US, and emerging markets. Fixed income assets under consideration were US aggregate bonds, US intermediate‑term credit, US short‑term Treasuries, US long‑term Treasuries, and hedged non-US bonds. Vanguard Capital Markets Model (VCMM) 10‑year projections as of 31 October 2025 were used.

Source: Vanguard analysis, January 2025

² Notes: Vanguard calculations are based on portfolios optimised by the VAAM, using return projections from the VCMM. Sharpe ratio is a measure of return above the risk-free rate that adjusts for volatility. A higher Sharpe ratio indicates a higher expected risk-adjusted return. Expected maximum drawdown is the median peak-to-trough drop in the portfolio’s value in 10,000 VCMM simulations. The probability of underperforming the benchmark is in any given year. 

Source: Vanguard calculations, as of 31 October 2025.