Understanding asset allocation

Asset allocation is the mix of underlying asset classes held within an investment portfolio. 

There are generally understood to be four main asset classes - cash, fixed interest securities, property and equities. Each asset class behaves differently with very different risk profiles.

Various academic studies have shown that asset allocation is the single most important factor in determining the returns of an investment portfolio. Secondary factors like fund selection or market timing are less important when compared to being in the right asset class (or mix of asset classes) at the right time.

This is not to say that stock or fund selection cannot sometimes make a difference to the performance of portfolios. 

Some fund managers do add value, but unfortunately it is virtually impossible to pick those fund managers who add value on a consistent basis. If you pick a 'winner' this year the odds are that it will be performing below the sector average after that.

It has been over twenty years since the original asset allocation research was conducted by Brinson, Hood and Beebower (1). They looked at the investment performance of 91 institutional pension funds between 1974 and 1983. The conclusion of this particular study, which was confirmed in a follow-up study in 1991 (2), was that asset allocation is responsible for over 90% of the variation in an investment portfolios return each quarter.

A more recent study by Roger Ibbotson (3) went on to question the validity and interpretation of the findings in the Brinson report. This report determined that asset allocation was responsible for only 40% of the variation between portfolios. The remaining variation came from factors including market timing, investment style and investment costs.

The Ibbotson study is controversial if you believe, as we do, that asset allocation is the main driver behind investment performance. But digging deeper into the research methodology Larry Elkin (4) published a paper explaining that the selection of 'good' funds is often cancelled out by the selection of 'bad funds', leaving the investor with an average return in each asset class.

Because no investor or financial adviser is able to consistently select the top performing investment funds in every asset class, a portfolio with an average (or, more often than not, below average) performance in each asset class is still driven by asset allocation rather than fund selection.

If you could find a way of picking the top fund managers in every asset class you could derive additional value from this investment approach, but we are yet to meet an investor or adviser who owns such a crystal ball (and is prepared to let others use it!).

1 Brinson, Hood and Beebower, 1986. "Determinants of Portfolio Performance".
2 Brinson, Hood and Beebower, 1991. "Determinants of Portfolio Performance II: An Update".
3 Ibbotson and Kaplan, 2000. "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?"
4 Elkin, 1999. "How Important is Asset Allocation?"

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