Why You Should “Fix” Your Asset Allocation
Investing has the special ability to turn human intuition on its head. What seems like sensible investment decisions often end up costing you in the long run.
One of the best examples is asset allocation. Your portfolio’s asset allocation – how you divide money among asset classes – should be based on variables such as your financial goals, risk tolerance, time horizon and the return potential of the asset classes. Maintaining a fixed asset allocation is a common principle of investing that is backed by research.
However, it may seem wrong at first glance. After all, if the performance of asset classes consistently change, doesn’t it make sense to change your asset allocation as well? Further, if one investment has shown better long-term performance than the rest, why not allocate all your money to that winning asset class?
You can’t predict asset performance
Asset allocation is a key driver of the variability of portfolio returns. In the landmark 1986 study, “Determinants of Portfolio Performance,” researchers Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower found that more than 90% of variation in portfolio returns can be attributed to asset allocation.
That means if you want to explain why your portfolio returns differ from a friend’s portfolio, the primary reason is different asset allocations. That might prompt you to think, if I want to beat my friend then all I have to do is actively change my asset allocation.
Figure 1: Negative effects of market timing and security selection, 91 large pension plans, 1974-1983
Source: Brinson et al. “Determinants of Portfolio Performance”
However, the Brinson study uncovered damning evidence against active investment strategies such as market timing and security selection. In its analysis of 91 pension plans from 1974 to 1983, shown in Figure 1, tinkering with your asset allocation, on average, had negative effects on returns. Market timing and security selection produced returns of -0.66% and -0.36%, respectively.
It turns out a gut feeling simply isn’t a reliable predictor for future markets.
You can’t trust a proven winner
Paradoxically, even if your intuition is right and you can pick the best performing asset class, it can still underperform a fixed asset allocation. In this Financial Planning article, author Allan Roth demonstrates how a mixed portfolio can perform better than its individual funds.
In figure 2, Roth uses Vanguard index funds to represent the annual returns of U.S. stocks, international stocks and bonds. Over a 15-year period, ending on December 31, 2013, U.S. stocks produced the best annual return at 5.38%. It seems logical to believe the highest return could only come from putting everything in U.S. stocks, as the other asset classes would only lower your overall return.
Figure 2: Annual returns over 15-year period of individual funds compared to mixed portfolios
Source: Allan Roth, Financial Planning
On the contrary, portfolios with a different mix of those individual funds, biannually rebalanced, would have performed better than the single U.S. stock fund over the same period.
Part of the reason is that rebalancing – selling a little of what went up and buying a little of what went down – to return your portfolio to your original asset allocation allows you to buy low and sell high. Therefore, maintaining a fixed asset allocation in your portfolio can produce better results than making the right bet on one fund.
What Roth doesn’t touch upon is that the average investor is unlikely to handle the major ups and downs that come from investing in a single asset class. You may have an intuition of what happens if that asset class drops at the end of your time horizon – you don’t reach your financial goals.
This doesn’t mean there are never instances when it’s okay to change your asset allocation. Generally, as personal circumstances change, it may be a good time to consider changing your asset allocation, including when:
- Your target retirement goal is well within reach
- You realize that you will not need all your money during your lifetime
- You have realized that your tolerance for risk is not as high as you thought
While your senses may help you make good decisions in many areas of life, it’s better to invest by following evidence rather than just simply following your intuition.