Sunday, March 28, 2010

Misconception Surrounding The Importance Of The Asset Allocation Decision

Many investment advisers will indicate that one of the most important variables an investor needs to determine is their asset allocation. The reason behind this has to do with a study completed over 20 years ago by Brinson, Hood and Beebower that indicated that 93.6% of an investor's return is attributable to asset allocation. I wrote a post on this study a few years ago titled, Asset Allocation: Pros and Cons.

In a study reported in the March/April 2010 Financial Analyst Journal titled, The Equal Importance of Asset Allocation and Active Management and written by James Xiong, CFA, Roger Ibbotson, Thomas Idzorek, CFA and Peng Chen, CFA, it is shown that asset allocation is not nearly as important as many believe. In another article in the March/April 2010 FAJ, The Importance of Asset Allocation (PDF), Roger Ibbotson provides a summary of the aforementioned study.

In the summary several important conclusions are noted:
  • many investors mistakenly believe that the BHB (1986) result (that asset allocation policy explains more than 90 percent of performance) applies to the return level (the 100 percent answer). BHB, however, wrote only about the variation of returns, so they likely never encouraged this misrepresentation.
  • In general (after controlling for interaction effects), about three-quarters of a typical fund’s variation in time-series returns comes from general market movement, with the remaining portion split roughly evenly between the specific asset allocation and active management.
  • Do the BHB (1986) time series have any meaning at all in explaining the incremental importance of a specific asset allocation policy? Not necessarily. Perhaps the simplest illustration was given by Mark Kritzman (2006) in a letter to the editor of this journal titled “‘Determinants of Portfolio Performance—20 Years Later’: A Comment.” Kritzman constructed an example in which stock and bond returns moved up and down perfectly together (i.e., were equal to each other each year) while underlying securities did not. The BHB methodology incorrectly ascribed all 100 percent of the return variation to asset allocation, whereas, in fact, all the variation came from stock selection and general market movement.
  • The time has come for folklore to be replaced with reality. Asset allocation is very important, but nowhere near 90 percent of the variation in returns is caused by the specific asset allocation mix. Instead, most time-series variation comes from general market movement, and Xiong, Ibbotson, Idzorek, and Chen (2010) showed that active management has about the same impact on performance as a fund’s specific asset allocation policy (emphasis added).
Investors are encouraged to read the Ibbotson summary to get a clearer perspective on asset allocation decisions.


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