Where Smart Money Goes.®
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Where Smart Money Goes.® |
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Asset Allocation and Portfolio Performance Studies have been performed to identify which factors contribute the most to a portfolio's overall performance. The studies analyzed the asset allocation, individual security selection and market timing decisions. Results from a study of 91 large U.S. pension plans from 1974-1983 indicated that asset allocation (investment policy) was the dominant factor in determining the portfolios performance [1]. The results are summarized in Figure 1 which shows the contributions of total portfolio return were asset allocation (94%), individual security selection (4%), and market timing (2%).
Asset
allocation is the process of selecting and dividing one's wealth among broad
asset classes or categories. In the
past, only three categories were considered (cash, equities and bonds).
Today a fully diversified portfolio can include equities, fixed income
instruments, international equities, real estate, precious metals, and cash
equivalents. Asset allocation
involves analyzing the risk return characteristics of each asset class rather
than the individual securities that comprise each asset class. This is an important distinction and lends credibility to the
use of passive rather than active strategies.
There
are four steps used to designing a portfolio [3].
The first step is choosing which asset class will be included in the
portfolio. Second, the
long-term percentages to allocated to each class must be determined.
Third, one must identify the ranges that each class can be modified to achieve an
optimal mix. Lastly, the
securities from each asset class must be selected. Traditionally,
steps 1 and 2 are known as the investment policy or asset allocation, step 3 as
market timing, and step 4 as security selection. All asset classes should be initially considered for the portfolio and then individual class can be eliminated if sound reasoning prevails. All classes must be analyzed to determine their impact on the overall portfolio since changes in economic conditions can affect asset classes in different directions and magnitudes. Modern
portfolio theory states that an investor would choose the market portfolio of
risky assets to combine with risk free asset.
Thus, a good starting point for long-term asset class percentages would be
the percentage of world wealth in the overall market.
However, the asset allocation must be a good fit for the investors.
Every allocation is slightly different depending on each investor’s
investment objective, total assets, cash flow needs, tax situation, risk
tolerance, and time horizon. The
goal is to determine the best asset class allocation that will meet the
investment objective at the lowest risk. The
third step involves setting a range at which the investor is willing to adjust
each asset class percentage. These
ranges can be used to increase or decrease allocation to the asset
class given short-term expectancies. A
word of caution: this procedure involves timing the market, something which empirical
evidence has shown cannot be done on a consistent basis as a means to achieve superior
returns. As such, this step is best
used to adjust portfolio allocations based on individual investor portfolio
preferences rather than as a means of trying to time the market. The
fourth step involves security selection. As
noted prior, security selection only contributes 4% to the overall portfolio
performance. One of the important
concerns with individual security selection for an investor employing a passive
investing strategy is to keep transaction costs and management fees as low as
possible. This is the reason that
Dimensional Fund Advisors (DFA) funds are employed by Karmikel Investments. DFA
offers mutual funds designed to capture the behavior of an entire asset class,
index funds engineered to capture specific dimensions of worldwide returns, and
fixed income strategies with a variable annuity structure.
In addition, DFA maintains very low management fees and has even achieved
negative trading costs over an extended period in the U.S. small company stocks.
Utilizing DFA’s broad-based funds and low cost management style allows
investors to achieve broad global diversification at minimal trading and
management fee costs. For more
information on DFA, see DFA funds
elsewhere on this site. Why
do so many investors subscribe to active investment strategies and overemphasize
security selection or market timing? Part
of the answer is tradition. Money
management was founded on the belief that one could beat the market and achieve
superior returns by stock selection and market timing.
In fact, many managers believe that without superior returns, money
managers would not exist. In
reality, time and again, research concludes that managers under-perform the
market and those who do outperform the market in one period have an equally
likely chance of under-performing in the next period. Other
reasons investors incorrectly choose active management is simply the seductive appeal.
It is the fun of it, the challenge of it, or the hope of "beating the
other guy." While particular money
managers may beat an index three years in a row, studies repeatedly reveal that it is merely due to random chance and not superior stock picking or
market timing. To illustrate these odds,
you may think of a coin toss: if you flip a coin
three times, your chances of getting heads three times in a row is 12.5%. Let's look at efficient portfolios. To
illustrate how efficient portfolios are created we will look at an example
comprising three main asset classes: T-bills, stocks, and bonds [4].
For graphical presentation, the efficient frontier is plotted in
mean-standard deviation region. First,
we will show the individual asset classes, then the two-asset efficient
frontier, and finally the
three asset efficient frontier. First,
we need some statistics to plot the efficient frontiers.
Table 1.1 presents hypothetical statistics relating to three asset
classes. For a more rigorous
explanation of the detailed calculations involved in creating Table 1.1,
see the
modern portfolio theory section elsewhere on this website.
Table
1.1
Plotting
the statistics from Table 1.1 creates the two-asset efficient frontiers
displayed in Figure 2 (below).
The individual stock, bond, and T-bill securities are represented by a
dot and are labeled accordingly. The
lower arc represents the full range of combinations of stocks and T-bills and
the upper twin humped line represents the stock/bond efficient frontier.
Notice that the two-asset portfolio dominates the single-asset portfolio
in several places.
This
is a simplified example but it none-the-less provides illustration of
diversification and what an efficient portfolio means.
As the possibility of securities expands and the number of assets
included in the portfolio grows the computations become more rigorous.
However, the concepts are exactly the same and an efficient frontier can
still be calculated and diagramed. Table
1.2 below shows actual statistics for range of risk tolerance portfolios from
1973 through 2001 [2]. Notice that
the standard deviations and expected returns increase from left to right as the
portfolios become more aggressive. Also
notice that the highest and lowest annual returns can and do lie outside of the
one standard deviation range of the annualized return.
This clearly shows that while the standard deviation is a good measure of
portfolio risk, it is based on regression analysis, which is an average of
the deviations from the average return, not an absolute range for each
of the annual portfolio returns. In
other words, actual returns can and will be less than and greater than the
standard deviation. However, over a
longer period of time, the average risk will trend according to the standard
deviation. This table shows, in
general, how different levels of aggressiveness affect a portfolio's risk and
return characteristics. Table
1.2
Figure
4 shows the portfolios from Table 1.2 in the mean variance standard deviation
region. The purpose of Table 1.2 and Figure 3 is to give an
example of general portfolio characteristics for common risk tolerances.
The equity and fixed income categories can be broken down into
subcategories. Equities are broken
down into U.S. and international equities.
U.S. equities can be further broken down into different capitalization
stocks (small, medium, and large) and value stocks.
International stocks include different capitalization (small, medium, and
large) and emerging market stocks. Fixed
income categories include subcategories of different investment grades and
maturity dates. The idea is to
allocate assets broadly among all asset classes and at weights that create an
efficient portfolio. To
summarize, we have illustrated that asset allocation is the single most important
determinate of portfolio performance. Active
managers attempt to use superior stock selection and market timing to beat the
market but a steady stream of empirical research shows that these managers only conform to
statistical chance. We presented an
example of a two-asset and a three asset efficient frontier.
We also presented a general look at the risk return characteristics of
broadly diversified portfolios at various risk tolerances. Works Cited 1.
Brinson, Gary P., L. Randolph Hood, Gilbert L. Beebower, “Determinants of
Portfolio Performance”, Financial Analyst Journal, July-August 1986,
pp. 39-44. 2.
Dimensional Fund Advisors data 3.
Gibson, Roger C., Asset Allocation: Balancing Financial Risk, Homewood,
Dow Jones-Irwin, Inc., 1990. 4.
Rudd, Henry and Henry Clasing, Jr. Modern
Portfolio Theory: The Principles of Investment Management. Orinda: Andrew
Rudd, 1988. Copyright © 2008 Karmikel Investments - ALL RIGHTS RESERVED
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Active vs. Structured Management Wealth Transfer, Legacy Planning & Charitable Giving
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