Asset Allocation

The determinant of investing performance


I  began saving for retirement in earnest pretty much mid-career when I figured out that I wouldn’t have a pension. I enrolled in the company 401K and also began buying mostly individual stocks via a broker. As the web grew and Charles Schwab opened up for business I moved all my holdings there so I could control my own destiny and cut costs significantly. I didn’t find the average stockbroker particularly brilliant anyway. I also began to migrate from individual stocks to mutual funds. As my portfolio grew, two critical questions emerged: 1. What should be in my portfolio? and 2. Did I need a financial adviser? I already answered the question regarding an adviser. So I put my effort into educating myself. After a good bit of research two foundational elements for my retirement investing emerged. The first was my portfolio should consist primarily of low—cost index mutual funds. The second was that asset allocation should be the cornerstone of my retirement investing strategy. Asset allocation is what people really mean when they talk about diversification.

Burton Malkiels’ “A Random Walk Down Wall Street” along with John Bogle, the founder of Vanguard Funds, convinced me that trying to beat the market is a loser’s game. Other research studies showed that investment returns are pretty much dependent upon asset classes and provided clear justification for asset allocation. All this stuff about researching the market and picking stocks was pretty much voodoo. Not only does asset allocation determine returns, it provides the primary means for controlling risk. My take-off point was and e-book, “The Intelligent Asset Allocator” by William Bernstein. (Now you have to buy the print version.)

There are several early significant academic research papers. One of the important early studies on the subject was “The Determinants of Portfolio Performance,” by Gary P. Brinson, L. Randolph Hood, and Gilbert P. Beebower, published in the Financial Analysts Journal of July/August 1986. It reviewed the returns of 91 pension fund portfolios and examined the relationship of returns and asset allocation. Based on this paper, investors and investment advisers have tended to believe that asset allocation explains at least 90 percent of portfolio performance. However, some serious questions were raised after publication of the study.

Roger Ibbotson and Paul Kaplan revisited the topic in 2000 in “The True Impact of Asset Allocation on Returns” to explain the study and investigate some criticisms. They started by stating that “…there is a universal misunderstanding of the relationship between asset allocation and performance.” The Brinson study did not explain what percent of return is determined by asset allocation but “Brinson is measuring the relationship between the movement of a portfolio and the movement of the overall market. He finds that more than 90 percent of the movement of one’s portfolio from quarter to quarter is due to market movement of the asset classes in which the portfolio is invested.” Ibbotson and Kaplan sort through this and run additional analyses and conclude that asset allocation explains 40 percent of the variation of returns across funds and 100 percent of the level of fund returns. On this latter point they say: “We can extrapolate from the study that for the long-term individual investor who maintains a consistent asset allocation and leans toward index funds, asset allocation determines about 100 percent of performance—regardless of whether one is measuring return variability across time, return variation between funds, or return amount.”

Another helpful paper that sheds a little more light is Asset Allocation Revisited, by William E. O’Rielly and James L. Chandler, Jr. The paper presents a study using “… a large set of mutual fund data and a random process of mixing mutual funds to test whether asset allocation is still as important today as BHB found it to be more than ten years ago.” Bottom line, the answer is yes. As a result I spent time trying to figure out what an asset class really was, which ones to choose and in what proportion.

One problem that I encountered early on was that I never did find an adequate definition of an asset class. There were numerous references and examples ranging from the simplistic ‘stocks and bonds’ to detailed enumerations. So I have attempted my own definition of ‘asset class’. An asset class is a collection composed of individual financial value generating assets that share fundamental and distinguishable characteristics, such as specific markets, ways of doing business, legal structures commercial practices, geographic and political differentiation and even a characteristic descriptive ‘language’. Individual elements of the class can be bought and sold. An asset class is usually represented by a publicly available index that aggregates quantifiable returns that can be used to compute correlations and volatility for comparison with other asset classes.

Like just about everything else of any consequence, asset allocation requires some investigation and thought. There is no one allocation for all. Each person must develop an asset allocation appropriate to his or her circumstances. Regular rebalancing of the portfolio is also required to properly execute an investment strategy based on asset allocation. In the follow-up to a webinar presentation some years ago Rob Arnott listed 16 indices that represent 16 “asset categories”. I have mapped each of these to an asset class. These examples represent fundamental asset classes. (There are thousands of indices out there, many of them overlapping as well as some that are quite narrow in scope. They can’t all constitute true asset classes, I hope.) Please note that there are alternative indices for most asset classes and some of the index providers listed here may have changed.

Asset ClassAsset Class Index
US Large Cap EquityS & P 500 Total Return
US Small Cap EquityRussell 2000 TR
International EquityMSCI EAFE TR
Emerging Market EquityMSCI EM TR
US Investment Grade BondBarCap Aggregate Bond
US Government Inflation Protected BondBarCap US TIPS
Emerging Market BondJP Morgan EMBI+
Long Term Government and Corporate BondBarCap Long Credit
Below Investment Grade US Dollar Term Bank LoansCSFB Leveraged Loans
US Government Short Duration BondML 1-3 Yr. Govt./Credit Short Duration Bond
Convertible BondML convertible Bond
Canada Large Cap EquityS&P/TSX 60
Real EstateFTSE NAREIT all REITs
CommoditiesDJAIG Commodities TR
US High Yield BondBarCap US High Yield
Emerging Local Currency Money MarketsJP MOrgan ELMI
  This list is pretty comprehensive but not exhaustive. For example, municipal bonds don’t seem to be included. You could also make a case to include Latin American equity indices as well as an intermediate term US Government bond index. I don’t really see a cash/money market index either and I don’t know where to put preferred stock. There is no one-size-fits-all asset allocation.

Each person must develop an asset allocation appropriate to his or her circumstances. For example if you are in mid-career your allocation can tolerate more risk. After retirement, it makes sense to shift to a more conservative allocation. From an individual investor standpoint, the manageable number of asset classes will, I suspect, be less than 16. A key selection factor is controlling risk, usually via a Treasury bond component. After considerable analysis I came up with a set of 9 asset classes that “feels right”. These are shown in the pie chart at the top of the page. The next part of the process is to create a portfolio mix of various percentages of each asset class. You cannot purchase an asset class per se. In my case the actual assets to purchase are the individual mutual funds (index funds generally), for example Vanguard S&P 500 index fund (VFINX) and the Vanguard intermediate bond index fund (VBIIX). The key is to maintain this allocation steadfastly over time by “rebalancing” at a regular interval. For practical purposes a year works well. The essence of rebalancing is to sell off assets from classes that have gained in value and buy those that have lost in value. The purpose is to get back to the original allocation percentages for each asset class. It is the discipline of the process that is important.

More on asset allocation

John Authers of the Financial Times talks about asset class choices for your portfolio.   In particular he outlines choices beyond stocks and bonds and provides useful explanations of hedge funds, private equity and commodities. He also reminds us that “…nothing ultimately matters more than keeping fees under control. ”

Read “Global Asset Allocation: A Survey of the World’s Top Asset Allocation Strategies” by Mebane Faber. It provides data on global historical asset returns, a good discussion of asset classes and analyzes asset allocations proposed by “some of the most famous money managers in the world.”