From the January 2025 issue of Personal Finance (“Tapping the Brakes“)

At the start of each year, I adjust our asset allocation model based on my expectations for the financial markets. A year ago, I increased our allocation to bonds while cutting back on inflation hedges.

I noted then, “With these changes to the PF Model Portfolio, it is now perfectly balanced. A 40/40/10/10 allocation among stocks, bonds, hedges, and cash implies an historically normal economic environment.” A year ago, I judged the relative risk in the financial markets to be balanced.

I closed that article by opining, “With less economic distortion to deal with, the financial markets should be able to function more consistently within their historical norms in 2024.” For that most part, that expectation proved true. Despite fears of a recession that triggered a brief sell-off over the summer, the stock and bond markets delivered another solid year in 2024.

I expect more of the same in 2025, but with increased volatility along the way. For that reason, I am taking a conservative stance towards asset allocation until we know more about what the new presidential administration has in store for us.

Taxes and Tariffs

The main reason I am expecting heightened volatility in 2025 is uncertainty over the promises made by president-elect Trump to cut income taxes and increase import tariffs. Each of those actions could be inflationary; combined, they all but assure a resurgence of inflation once they have been fully implemented as currently conceived.

Wall Street will be paying close attention to that possibility, which is what makes this exercise tricky. Presumably, the new president will be able to force both items through Congress given the republican majority in the Senate and the House. However, there is already pushback within the party, suggesting either one or both of those items may take longer to pass than expected, and even then, in a watered-down form of what was proposed.

The institutional money managers on Wall Street will protect their portfolios until they know exactly what form those two items will take. They can do that by purchasing options on stock and bond indexes, thereby leaving their existing portfolios intact (and deferring taxation on any unrealized appreciation on those holdings). They may also buy futures contracts on certain commodities if they fear a resurgence in inflation is in the offing.

Risk Off

For those reasons, I am increasing our allocation to cash and inflation hedges by 10% each while reducing our stock and bond allocations by an identical amount. That changes the overall allocation to stocks, bonds, hedges, and cash from 40/40/10/10 to 30/30/20/20.

To be clear, I am not expecting a stock market crash. If I were, I would go heavier into bonds and cash to protect principal. Instead, I am expecting a sloppy market with several stops and starts before it develops an equilibrium that reduces volatility.

Of course, all those things could be outweighed by a single “black swan” event, such as the COVID-19 outbreak five years ago in which case all bets are off. Also, the escalation of a regional war in Asia, Ukraine, or the Middle East that involves the United States could send Wall Street running for the exits.

If something like that does happen, I may make a mid-year correction to our model portfolio depending on the circumstances. Right now, we really don’t know what the national economy will look like under Trump. As far as I’m concerned, it would be fine with me if 2025 ended up looking a lot like 2024.

Editor’s Note: This allocation model is not intended as specific investment advice, but to illustrate the relative value of the major asset classes included in the portfolio. How you choose to diversify your personal portfolio is a function of many variables including risk tolerance, performance expectations, and time horizon. An increase or decrease in any of these asset classes does not necessarily mean that we believe that asset class will rise or fall in absolute terms, but that we believe it is likely to perform better or worse on a relative basis to the other asset classes.