Debunking an Investment Myth
I've HAD it! I'd like to put to rest an investment "myth" that comes up all too often.
I've seen it in financial articles and advertisements and heard it repeated by both educators and advisors. Perhaps you've come across this, too: "Asset allocation is responsible for more than 90% of a portfolio's return."
In other words, the key to getting the best return on your money is knowing how to divide it up among stocks, bonds and cash. The problem is, this makes it sound as if all you need to do is come up with the magic combination and -- voila! -- you get a winning portfolio. It implies that if you get the allocation right, you can even choose lousy stocks and mutual funds for each category, because individual security selection has very little to do with the return you get.
Well, it isn't true.
So where did it come from and why do so many people believe it?
This "common wisdom" is a result of people misinterpreting the results of research conducted back in 1986 by a team of academics led by Gary Brinson. They wanted to find out how much of an impact various factors such as market timing, security selection and asset allocation could have on a portfolio's return.
To do this, they studied the performance of 91 pension plans over the 20-year period from 1974-1983. They described asset allocation as the "investment policy" a pension plan adopts and concluded it is responsible for "...explaining 93.6% of the variation in total plan return."
The investment community jumped on this, interpreting it to mean that the biggest influence on portfolio return is how the assets are divvied up. Suddenly, pie charts sprang up everywhere!
Trouble is, this conclusion overlooks a critical word: "variation." As in, the gain/loss your portfolio experiences compared to, say, your sister's. Professionals think of this as "volatility" or "risk."
The Chicago-based investment consulting firm, Ibbotson Associates, tested the conclusion reached by Brinson et al. in two separate studies: one using pension plan results and the other comparing returns on portfolios made up of mutual fund returns. This study, published in January 2000, found that asset allocation does, indeed, matter -- but not as much as the "common wisdom" thinks.
Ibbotson concluded that asset allocation can explain roughly 40% of the variation -- or difference -- in the returns two portfolios produce. For example, let's look at the portfolios of two hypothetical investors, Luci and Desi. Both have divided their investments among three different types of mutual funds: equity funds, bonds funds and money market funds. However, Luci's overall portfolio return is 15%, while Desi's is 10%. How much of Luci's extra return was due to the percentage she allocated to each category?
The Ibbotson study found that about two percentage points (40% of the 5% difference) "...is explained by the different asset allocation." That is, less than half of the variation between these two portfolios was due to the way Luci divvied up her money.
What explains the rest of the difference, that is, 60% (3 percentage points) of Luci's additional return? According to Ibbotson it comes down to "security selection, timing, and fee differences between the funds."
What does this mean to the average investor? Picking well-run mutual funds matters! It is more important to focus on how your money is managed than on how it is allocated. Do the fund managers have a disciplined investment process? Do they do extensive research on each potential -- and current -- holding to determine whether to buy and when to sell? These studies tell us that factors like these can have more of an impact on performance than allocation alone.
What asset allocation does do is affect the potential return your portfolio will have. That's because it the more risk you expose your portfolio to, the greater its potential for gain or loss. So, by increasing your exposure to more volatile (or "variable") market sectors such as stocks, you increase the potential for higher returns... and larger losses.
Just don't leave it there. It's important to choose the right stocks or stock mutual funds to fill that allocation. As Morningstar, the mutual fund tracking firm, said in September 1997: "Certainly managing risk through asset allocation affects return. The more risk investors take on, the greater the potential returns... Risk management may be much of the game, but good fund-picking generates even better results."
One more thing: In 1975, Roger Ibbotson was scoffed at by the financial industry when he predicted that the Dow Jones Industrial Average would reach 10,000 by November 1999 . (OK, so he was 8 months early -- not bad for a 25-year forecast!) He has now lowered his forecast for future returns in the stock market based on the declines we've seen in the past three years. Ibbotson is now calling for a total return (price appreciation plus dividends) of 8% annually.
In case you haven't been to the bank lately, 8% beats the pants off CDs, treasury bonds and just about every other legal investment currently available. (And in investing, as with most everything else, it's all relative.) So don't give up on stocks. As Auderbach points out, "If you're sitting on the sidelines, it's easy to miss a recovery. It can happen quickly. In fact, you can be in one and not realize it until later."
So evaluate your asset allocation based on your risk comfort level and time horizon. Work with your financial advisor to do this properly. Remember that diversification does reduce volatility and help protect your principal. However, it is possible to lose money, even in a diversified portfolio. Consider the risks -- but keep the faith. If Ibbotson is right, and stocks return 8% a year, this portion of your portfolio has the potential to double in value in 9 years.
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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.