Asset Allocation: How Important?

 

Exactly how important is the portfolio policy on portfolio return and how is it measured? Research papers from the late 1980s through the early 2000s tell us it is very important. That is, anywhere from 90% to 100% of the return of the portfolio is tied to portfolio policy.  Let me quickly insert that several studies are frequently misinterpreted.  While the papers focus on portfolio variation, second-hand writers imposed the word return, giving an entirely different meaning to the research.

If asset allocation is all important, are other factors of zero importance? What about stock selection, market timing, costs, etc.  Recent research from Ibbotson indicates stock picking is approximately 12.5% of the return while asset allocation contributes another 12.5%.  The remaining 75% comes from market action itself.  In other words, we cannot control how the market moves despite our best efforts regarding asset allocation.  This research makes more sense than research conclusions we had just a few years ago.  However, one needs to question any conclusion that measures to three significant figures something as elusive as the stock market.

When the "importance of asset allocation" studies are conducted, asset classes are divided into equities, bonds, and cash.  While this simplifies the variables for the academic studies, those three asset classes do not represent what most asset allocation oriented investors use when constructing a portfolio.  Three asset classes are far too limiting.  While it may be out there, I know of no asset allocation study that uses 10 to 15 asset classes over a 30 to 40 year period or the investing lifetime of an average worker.  The complexity of such a study would be extremely challenging.

Does the challenge posed by such a study throw a spanner into the gears when it comes to laying out a Strategic Asset Allocation (SAA) plan?  Not in the least.  If for no other reason, investors should have a SAA plan in place for diversification purposes as risk protection.  While we pay much attention to return, equal attention is given to risk or portfolio uncertainty.  How one reaches the return of a portfolio is intimately tied to the uncertainty percentage of the return or risk. Portfolios tracked here at ITA Wealth Management give considerable importance to both return and portfolio uncertainty. The ratio is reported in two forms.  One is the Sortino Ratio (SR) and the second is the very high bar known as the Retirement Ratio (RR).

While we are not prepared to lay a percentage on the value of asset allocation, we consider it vital to portfolio stability, return, and diversification.  For these reasons, asset allocation is front and center when it comes to laying out the SAA plan for investors.