Introduction to Asset Allocation


Much of economics is about how to allocation scarce resources to achieve a goal or goals.

Often, there are constraints imposed on allocation decisions (e.g., you can't invest more than $10,000 in X). And most of these decisions have to be made in the face of uncertainty - situations where the decision maker does not know (and often cannot know) the full range of possible future outcomes, or their associated probabilities. And in the real world, these decisions often have to be made in the face of time pressure and with limited information.

From this perspective, deciding how to divide a portfolio between different investments is just one of a larger class of asset allocation decision problems. Yet too often, real world investors spend too little time on it, and fail to take into account lessons that have been learned by people who have faced similar allocation problems in the world outside of finance.

How you choose to allocate your investments between broadly different types of assets (that is, between "asset classes") is the most important decision you make when it comes to determining whether or not over time you 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 from our perspective their returns all have relatively high correlations with each other, which makes them all members of the same 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. In our model portfolios, we use up to ten different broadly defined asset classes, including real return bonds, domestic nominal return bonds, foreign currency bonds, domestic commercial property (real estate), foreign commercial property, commodities, timber, domestic equity, foreign equity, and emerging equity (we also use uncorrelated alpha strategies, but technically they are not an asset class). We'll shortly discuss these asset classes in more detail.

But first, let's take a closer look at the importance of asset allocation. 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.

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. 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.

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.

Consider the findings from four widely cited studies on this issue. 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. The third is "Asset Allocation Versus Security Selection" by Mark Kritzman and Sebastian Page. And the fourth is "Is There Really a Hierarchy in Investment Choice?" by Assoe, L'Her and Plante.

The Kitzman and Page 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. However, Assoe, L'Her and Plante pointed out that Kritzman and Page ignored the tradeoff between potential returns and the additional risk that investors must accept when they seek those returns via security selection. The authors found that from the perspective of potential risk adjusted returns, asset allocation and security selection were equal in their potential portfolio impact.

The other two studies looked not at theory, but rather 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 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 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. However, this large spread between the returns generated by top quartile compared to other managers points to a final critical issue: an investor's confidence in his or her ability to identify asset managers who are truly skilled rather than just lucky. And as we shall see, this is very, very hard to do.

So, back to our original question, "how important is asset allocation?" Our conclusion is that, as a practical matter, in most cases it is the key determinant of your portfolio's long term rate of return.

But how do you determine the long term rate of return you need to earn in order to achieve your financial goals?

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