Introduction
I like to look into asset allocation research, and I like the statement: Asset allocation is thus the only factor affecting your investments that you can actually influence. No one can achieves long-term success in the former (market timing), and almost nobody in the latter (selection of a good stock/bond).
Research review of asset allocation
In the late 1980s, Gary Brinson, a noted money manager and financial analyst in the US, along with his colleagues, published two comprehensive research studies of 82 large pension funds. They concluded that asset allocation accounted for over 90% of the return variability among the funds (in other words, 90% of the difference in return among two pension funds was due to their asset allocation strategies), with a less than 10% contribution from market timing and actual stock and bond selection.
Another research done in 1996 pegged that a long term portfolio’s performance is almost 92% determined by asset allocation and less than 7% by market timing and individual stock or bond selection combined (see chart below).
In other words, what these studies indicate is that asset allocation policy is 10 times as important as stock picking and market timing combined. In recent years, many observers and investment experts have suggested that the 90% figure is too high; perhaps asset allocation accounts for only 50% of return variability.
You see, such arguments completely miss the point. Market timing and selecting a good stock or bond is obviously important. The only problem is that nobody achieves long-term success in the former (market timing), and almost nobody in the latter (selection of a good stock/bond).
Asset allocation is thus the only factor affecting your investments that you can actually influence. Finding the right balance between high risk (like stocks) and low risk (like bonds or cash) investments is the key to managing risk in a portfolio. That’s the power of asset allocation in your hands.
Risk
We all worry about the market risk, economic risk, political risk, and inflation risk. But we never give an iota of thought on what we can call the ‘personal risk’?
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