Asset Class Allocation and Portfolios: Critique and Complication

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In Part 1 of this essay, I explained that for asset class allocation to become an investment practice, it required a foundation of theory. And Modern Portfolio Theory was that foundation. But today, most financial journalists and investment advisors who proffer advice centered on asset class allocation are—if I may judge from their writings—oblivious of this. And why shouldn’t they be? Theory is abstract and difficult to apprehend.

So a foundational theory alone was insufficient for building such a prominent edifice of practice. There also had to be a superstructure of evidence, concrete facts that clearly attested to the efficacy of asset class allocation. Plausible evidence, which was easily apprehended by financial journalists and investment advisors, appeared in a research paper that was published in 1986.1 This is one of the most widely cited and misunderstood papers in the field of investing. Even its own authors seem to have misunderstood it, though not as egregiously as the many careless investment writers who imagined that they were echoing its conclusions to the public. But all the same, with this paper, asset class allocation at last became identified with good investment practice.

The paper’s authors looked at pension plans, not mutual funds or private portfolios, and only to the extent that those pension plans held stocks, bonds, and cash. (Back in the early 1980s, few pension plans invested to any great degree in other asset classes or in alternative investments, like hedge funds.) The authors’ conclusions, from their analysis of a database of pension plans’ changing values over a span of time, were that asset class allocation, rather than the selection of investments within the asset classes, was far and away the major source of investment returns, and that, on average, asset class allocation explained more than 90% of the variability of a pension plan’s returns.

Let’s scrutinize that last statement. It has led to countless mistaken repetitions of the claim that asset class allocation is the source of more than 90% of a portfolio’s returns. Please note, unlike so many investment professionals, the unsubtle difference in wording: The paper did not say 90% of the returns, but 90% of the variability of returns. Yet, to cite but one example, in the week that I am writing this paragraph, I read in Barron’s that “Most investors have heard the axiom that 90% of portfolio performance can be explained by their allocation decisions.”

Even the paper’s stated finding, concerning variability (or volatility), is unremarkable; it could have been foretold without crunching numbers. The returns of stocks, as an asset class, are much more volatile than the returns of bonds, let alone cash. If one portfolio is invested 90% in stocks and 10% in cash, and a second portfolio is 10% in stocks and 90% in cash, which one will have the more volatile returns? The first, of course. This will be true even if stocks end up at the same price from which they started during the period of our analysis, or if they go down. It will also very likely be true whether stocks, as an asset class, are represented by only a handful of names or by an index fund, or whether the managers make judicious shifts over time in response to changing economic forecasts or keep their allocations constant.

Consider, by analogy, that you’ve been informed that the ability of a group of people to walk directly from point A to point B, as measured by their cumulative wanderings off the straight course, is determined by the allocation of ages within the group: what percentage are under five years old, what percentage are between five and ten years old, what percentage between ten and fifteen, and so on. Of course it is! It’s almost entirely dependent upon the percentage consisting of peripatetic children under the age of five. Everyone else, of whatever age, will follow the instructions to walk directly from A to B. The relative proportions of the other age groups are beside the point. So, similarly, the conclusion that asset class allocation explains most of the variability of returns was both obvious and trivial.

See full article on Asset Class Allocation and Portfolios: Critique and Complication by Adam Jared Apt, Advisor Perspectives

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