How you choose to allocate your investments between different types of assets (that is, between "asset classes") is the most important decision you make when it comes to determining whether or not your portfolio will earn the minimum rate of return you need to meet your goals. Unfortunately, this "asset allocation" decision is one that most people don't spend nearly enough time thinking about before they make it.
Asked to define the meaning of "asset allocation", most people say that it has something to do with the way you divide your investments between different groups of similar assets. Unfortunately, this overlooks another important question, which is arguably far more important in terms of its impact on the returns you earn and the risks you take. Here's what we mean: Ask five of your friends to identify the different asset classes in which they've considered investing. You are almost certain to hear answers that include "growth stocks", "value stocks", "bonds", "small caps", "mid caps", and occasionally "international stocks."
The problem with these answers is that they are either too narrow or too broad. Given that the reason you diversify your investments across different asset classes is to minimize the riskiness of your portfolio, you want to avoid investments whose returns tend to move too closely with each other (statistically, you want to invest in asset classes whose returns have a low correlation with the returns on other asset classes in the portfolio). Given this, the problem we have when someone says "growth stocks", "value stocks", "small caps" and "mid caps" is that all their returns have relatively high correlations with each other, which makes them members of the same broad asset class: domestic equities.
Unlike the four flavors of domestic equities noted above, the other asset class definitions are too broad rather than too narrow. For example, assuming "bonds" means "domestic bonds", this could refer to not one, but at least three different asset classes: real return bonds (that protect you against inflation); investment grade bonds (that protect you against deflation); and high yield (also known as "junk") bonds that are more problematical in terms of their risk/return tradeoff. The same is true of "international equities". This could mean developed country equities from Europe or the Pacific Region, or it could mean Emerging Market equities. By now you've got the point (actually, you probably got it a while back, but have been bearing with us because you're polite): While the actual allocation of your portfolio to different asset classes is important, the definition of the asset classes you consider is equally critical.
But let's put that behind us, and move on to the next logical question. Just how important is the allocation of your assets between different asset classes? This is one of our favorite questions, because it is so frequently answered incorrectly. Unfortunately, there is no simple answer. Consider two investors, who (to simplify matters), have to answer two questions: how to allocate their portfolios between three asset classes, and whether to implement this strategy using index funds or actively managed funds. How important is asset allocation (as opposed to manager or security selection) to the returns they achieve? There are four ways to answer this question, and they are all correct.
(1) If the two investors choose different asset allocations, but both implement their strategies using the same index funds, then asset allocation accounts for 100% of the difference in the returns they achieve after ten years.
(2) Similarly, if they have the same asset allocations and implement them through the same index funds, asset allocation again accounts for 100% of the returns they achieve.
(3) On the other hand, suppose they both have the same asset allocations, but choose different actively managed funds to implement their common strategy. In this case, asset allocation would account for zero percent of the difference in the returns their portfolios achieve after ten years. All of the difference would be due to some combination of manager selection (by our two investors), stock picking skill (by the portfolio managers of the funds each one invests in), and the costs and taxes incurred by the respective funds.
So far, each of these answers has been pretty straightforward. The far more difficult situation is the fourth one, in which our two investors have different asset allocation strategies and choose different actively managed funds to implement them. In this case, the answer has been the source of quite a bit of controversy and disagreement between academics and industry players. The key disagreement is over the right measure you should use to answer the question. Three widely cited studies on this issue have been conducted. The first is titled "Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?", by Roger Ibbotson and Paul Kaplan. The second is "The Contribution of Asset Allocation to Portfolio Performance", by Wolfgang Drobetz and Friederike Kohler. And the third is "Asset Allocation Versus Security Selection" by Mark Kritzman and Sebastian Page.
This last study started out with a common sense insight: due to the benefit from diversification, the standard deviation of returns (a statistic which measures how widely they are distributed around their average) on an asset class index will inevitably be smaller than the average standard deviation of returns on the underlying assets that comprise that index. From this they concluded that, in theory, the additional returns that potentially can be earned from smart selection of securities within an asset class should be greater than the additional returns that can be earned from smart allocation of one's portfolio across different asset classes. Kritzman and Page then performed a simulation analysis that confirmed their intuitive result that security selection should, theoretically, have a greater impact on portfolio returns than asset allocation.
The other two studies looked at what accounted for the returns that were actually earned by real portfolio managers. Ibbotson and Kaplan used ten years of data from the United States on the performance of balanced mutual funds (that invested in different combinations of bonds and stock), while Drobetz and Kohler used seven years of data on balanced mutual fund performance from Germany and Switzerland. Both of these studies reached similar conclusions.
One way to measure the impact of asset allocation is to see how well a fund's basic asset allocation strategy explained the returns it earned from year to year. To do this, each study performed a regression analysis, in which the independent variable was the weighted performance of the basic asset allocation (e.g., if stock was 60% of the fund, and earned 10%, while bonds were 40%, and earned 5%, the asset allocation measure for the year would be 8%), and the dependent variable was the actual performance of the fund. As you might guess, the range of answers was wide. The 90% confidence range for one study was 47% to 94%, while for the other it was 58% to 96%. But what does this really tell us? In actual fact, it doesn’t tell us much at all. Some funds apparently stuck quite closely to their basic asset allocation policy, while others did not. What this measure doesn’t tell us is whether these active management departures from funds’ basic asset allocations ended up benefiting or hurting investors.
To answer that question, you need to use a different approach, and both studies did so. For each fund they compared the compound annual return earned over the study period by the base case asset allocation to the compound annual return actually earned by the fund (both before costs and taxes). If the ratio between the two returns was less than 100%, active management had added value; if it was greater than 100%, active management had destroyed value. The results of this analysis were not pretty (if you are an active manager). In the first study, the 90% confidence range was from 86% to 113%, and in the second it was from 101% to 180%. In other words, most funds studied (especially those in Germany and Switzerland) were destroying value through active management. Therefore, by this measure, asset allocation policy was responsible for almost all the returns earned by investors.
Kritzman and Page did not ignore these results in their study. Rather, they concluded that the reason why asset allocation has a relatively large impact on returns in practice is because many portfolio managers face serious constraints on their willingness and ability to actually engage in security selection (e.g., compensation plans which link their pay to their performance relative to an asset class benchmark, rather than to their ability to deliver absolute returns at or above a given target level). Other evidence seems to support this view. For example the spread between the average performance of top quartile and bottom quartile active managers is relatively small in asset classes with liquid assets and high trading volume (such as public equity and investment grade bonds), while it is much higher in less liquid asset classes (e.g., such as private equity and venture capital) where managers aim for absolute return targets, and earn high fees only when they meet or exceed them.
So, in answer to our original question, "how important is asset allocation?" our conclusion is that in most cases it is likely to be the key determinant of your portfolio's long term rate of return.
Before you determine the asset allocation that is best for you, you need to Quantify Your Portfolio Goals.