My favorite investment writer is William J. Bernstein, author of several investment books and the editor of the Efficient Frontier. This morning I was scanning the data files of ITA Wealth Management and found where one reader clicked on one of the older articles from Bernstein’s Efficient Frontier. [Be sure to read the section, 'Let George Do It.'] I myself have written about the Brinson et. al. articles, published back in 1986 and 1991. Those two articles are part of an asset allocation file 5.0 cm thick, stored in my filing cabinet. Since those original Brinson papers were published, Ibbotson and Associates conducted several follow-up studies. Their results as to the importance of asset allocation are all over the map. The latest results, and I may not be up on the most recent studies, conclude that the broad movement of the market controls 75% of the movement of the portfolio. The remaining 25% is divided equally between asset allocation and security selection.
The problem I’ve always had with these studies is that they segment asset classes into equities, bonds, and cash. To my knowledge, no study breaks the asset classes down any further. Why not divide equities into U.S. Equities, developed international markets, and emerging markets. Divided bonds between U.S. Bonds and International Bonds. Should anyone ever run into such a study, be sure to pass along the reference.
Bernstein sums up the asset allocation issue succinctly with this message to the small investor.
“So how important is “asset allocation?” Wrong question. More relevant to the investor is the question of how worthwhile professional efforts at both asset allocation and security analysis really are. The film “Less Than Zero” comes to mind.”
For small investors the answer seems to be:
- Decide how much equity you can stomach, and adjust your stock/bond allocation accordingly.
- Allocate your stock assets among a wide variety of global regions in a prudent manner.
- Let George do the rest while you get on with life’s more salient matters.
Can you stomach a stock/bond mix of 80/20, 70/30, or 60/40, knowing that even with 40% investing in bonds, over 90% of the portfolio volatility is linked to the 60% stock holdings? For more on portfolio risk, reread this article, and then look up Risk Parity under the Categories section.