The importance of asset allocation

By John De Goey on April 16, 2017
Estimated reading time: 2 minutes

Only two out of four elements are important when designing a portfolio. But most advisors and investors tend to focus on the wrong ones

One of the most quoted (and misunderstood) papers in the history of finance was one written by three researchers led by Gary Brinson. The research looked into the performance of a multitude of American corporate pension plans and showed that investment policy—the strategic mix of stocks, bonds, and cash—explains over 90% of a portfolio’s variance (or risk). Another interesting bit from the Brinson research showed that pension plans lost an average of 0.66% in returns as a result of market-timing activities. The research further showed that an additional 0.36% was lost as a result of security selection (i.e., stock picking). Would it surprise you to learn that many financial advisors suggest they “add value” with their superior abilities as market timers and/or stock pickers even though such positive outcomes are unlikely?

Portfolio design

Let’s look at the four main steps to portfolio design and their implications as indicated by Brinson and his team. These are spelled out as follows at the conclusion of their paper:

Deciding on asset classes to be used (which are included, which are expressly not included)
Deciding on normal long-term weightings for each of those asset classes
Strategically altering the mix in order to try to capture excess returns (market timing)
Selecting individual securities in order to try to capture excess returns (stock picking)

The authors showed conclusively that the first two points were critically important, while the second two were of minor consequence. Accordingly, they advised money managers to focus squarely on setting and maintaining a suitable asset mix. The evidence suggests that investors should focus strategically on investment policy.

Fact vs. opinion

So why do most advisors focus on the relatively unimportant tactics of market timing and security selection? Even worse, to the extent that market timing and security selection have an impact on performance, the difference seems to do more harm than good, and any beneficial results are outliers, yet many advisors persist in doing things the old way. Again, there are many advisors who, astonishingly, are unaware of the Brinson research even though it is of critical importance and came out a generation ago. I’ll leave it to you to draw conclusions. There’s evidence that many people make decisions based on rule-of-thumb shortcuts that often hurt their own self-interest (i.e., performance). There’s evidence of factors that consistently explain expected risk and return. We need to discuss the basic concepts of fact (things based on the best available evidence) and opinion (things that we believe even if we have no hard proof). It seems some people have difficulty in telling the difference. This is an excerpt from The Professional Financial Advisor IV (Insomniac Press), a guide that explores the complex relationship between investors and their advisors. John J. De Goey CFP, CIM, FELLOW OF FPSC is a Portfolio Manager with Industrial Alliance Securities (iAS) and the author of The Professional Financial Advisor IV. The views expressed are not necessarily shared by iAS.