Investing Classroom: Asset Allocation is 'It'?

Portfolio lesson 5.4: Should you focus all your investing efforts on asset allocation alone?

Morningstar 18 March, 2010 | 4:09PM

Conventional investment wisdom says asset allocation--or how you divvy up your assets among stocks, bonds, and cash--is what drives a portfolio's return. In the minds of many, time spent on security selection, or looking for great investments, is time wasted.

Like most common knowledge, this "wisdom" is rooted in research. A 1986 study by Gary Brinson, Randolph Hood, and Gilbert Beebower (BHB, for short) created a widespread obsession with asset allocation. By the mid-1990s, however, the investing community began to question BHB's findings--or, more precisely, how BHB's findings were being interpreted and applied to portfolios.

This lesson will discuss what BHB's study found, what critics have to say about it, and how you should think about asset allocation and security selection in your own portfolio.

What BHB says--and how it was interpreted
Brinson, Hood, and Beebower's study (also known as "Determinants of Portfolio Performance") found that the mix of stocks, bonds, and cash determines how volatile your portfolio will be.

The trio compared the actual quarterly total returns of 91 major, actively managed pension funds over the 1974 to 1983 period against the performance of a theoretical sibling fund that held the same average asset allocation (stocks, bonds, cash), but which indexed its investments. When measured by a linear regression, these comparisons yielded an average R-squared score of 93.6.

The bottom line? BHB concluded that asset allocation explained 93.6% of the variation in a portfolio's quarterly returns.

Asset allocation became "it," the secret to successful investing. Investors began to focus on their asset mixes rather than on buying hot funds. The study alerted them to the importance of having goals and choosing the combination of stocks, bonds, and cash that would allow them to reach those goals. Soon every magazine was printing model asset allocations.

What the critics say
The new approach was in many ways salutary. Yet critics--including William Jahnke, author of "The Asset Allocation Hoax"--pointed out that all this talk about asset allocation was based on a misguided interpretation of BHB's findings.

BHB's paper was not about total return. It was about volatility. Yet investors assumed that asset allocation influences long-term return as much as it influences volatility. And as the critics noted, volatility and return may be related, but they're two different things.

Regressions, such as those used in BHB's study, indicate pattern, not magnitude. For example, a portfolio manager who picked a diversified pool of stocks that beat, say, the FTSE 100 by exactly two percentage points each and every quarter would technically notch an R-squared of 100. Clearly, far less than 100% of the fund's total return would owe to its asset allocation, though.

The interpretation problems aren't confined to funds with high R-squareds. Consider the portfolio manager who, believing that the inflation scare of 1979 was about to repeat, put everything in an indexed basket of UK gold stocks. Because gold stocks dance to their own music, such a portfolio would post a very low R-squared by the terms of the BHB study. Does that really mean that asset allocation played only a modest role in that portfolio's returns? Hardly. In fact, the portfolio's entire performance would seem to have stemmed from the manager's decision to forego issue-by-issue selection and purchase a basket of gold stocks.

Of course, managing risk through asset allocation affects return. The more risk investors take on, the greater the potential returns. But investors still can add value through choosing great stocks or funds.

What you should do
Ultimately, putting a single figure on the importance of asset allocation is fruitless. Even if a better method could be found than was used in BHB, the answer couldn't be generalised.

Because we don't know what's going to happen in the market next, treat asset allocation and security selection as equals in the portfolio-building process. Determine how much risk you're willing to take on and what your goals are, and build your asset mix around them. Then, try to maximise your return within each asset class by choosing great investments.

For more investing lessons on equities, bonds, funds and portfolio management, check out our Learning Centre.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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