What You Should Know About Asset Allocation

The purpose of this article is not to say that the concept of asset allocation is flawed or anything like that. The most important decisions in determining an investment portfolio are what asset classes to use and what percentages to put into each asset class. Diversifying your funds among different assets among different kinds of investments potentially reduces your overall risk because different investments should act differently at different times for different reasons. This is a very sound and accurate description of the investment world.

See Also: How to Build the Right Mix of Investments in Retirement

What I want to call your attention to when it comes to the idea of asset allocation is a commonly used—actually, misused—statistic. You have very likely seen somewhere in marketing materials out there that 93.6% of the investment returns you get are due to the asset allocation of your portfolio.

This is simply not true.

Why am I writing about it now? Because in the last couple of months I've seen this misconception, or misunderstanding, a couple of times in some marketing materials that have come my way, and I wanted to share with you what Paul Harvey would call "the rest of the story."

The basis for this misunderstood issue comes from a 1986 article in the Financial Analysts Journal, titled "Determinants of Portfolio Performance," authored by Gary Brinson, L. Randolph Hood and Gilbert L. Beebower. The major tenant of the paper was that asset allocation mattered more than anything else—more important than even the specific stock or bond security selection or market timing.

The study looked at several specific pension funds over a specific time frame and reported on the variations in portfolio returns. It found the key driver of those returns was the choice of the asset classes used and the proportion that went into each asset class.

Here's where things get a bit confusing, and it stems from how the investment industry decided to use this information. Having been in the industry for more than 30 years, I've seen it time and time again. The marketing material will state that 93.6% of the return of your portfolio will come from the asset allocation of that portfolio. They have extrapolated the results of the Brinson, Hood, Beebower study and asserted that it applies to any and all portfolios over any time period. However, that 93.6% came only from the specific pension plans studied for that specific time frame, not any other portfolio over some other time frame.

As the risk of being really picky here, this is where the marketing departments of the financial services companies have gone too far. It's really simple to trot out the 93.6% number and make people think that the only key thing is asset allocation. Way too simple. And way too misleading. But it makes for great marketing material.

This comes full circle in an article published in March 2006 in Wealth Manager magazine, written by James Picerno, in which he interviewed Gary Brinson about his study results from twenty years before.

What did the author hope you would understand?

Summarizing the research, Mr. Brinson stated that deciding what asset classes to use and what percentages to use in those asset classes would have the biggest impact of the performance of the portfolios studied, and that those conclusions have stood the test of time.

Mr. Picerno then asked "Is there any particular misinterpretation or misuse that you find especially annoying?"

Mr. Brinson replied, "There's one quote that I see periodically. Let's say a portfolio had a return of, say, 10%, and someone will say, '93.6% of the return is due to asset allocation.' That's not true. That's not what the paper said; that's not the application of the paper. First of all, it didn't apply to an individual portfolio; it applied on average to the portfolios we were examining. The number is an average number, not a number that applies to every single portfolio."

Enough said?

So, please be aware of the misuse of the 93.6% statistic or any other percentage used in the same manner. If what you are reading or what is being presented to you is saying that the overwhelming percentage of investment returns is coming simply from asset allocation, know that the information is being misinterpreted or misused.

Take it from the author, Gary Brinson: this is not accurate. This is not a true statement. Be informed and be aware.

See Also: 7 Worst Mistakes Investors Will Make in This Market

Charles C. Scott, Accredited Investment Fiduciary®, has more than 30 years of experience in the financial services industry. "Our mission is to help our clients discover, design and live the life that they want to live by matching their finances with their visions, values and goals."

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