Proper Asset Allocation

In 1952, Dr. Harry Markowitz published a seminal work on the nature of investments and investment markets, a body of ideas that later came to be known as Modern Portfolio Theory (“MPT”). Key tenets of MPT have become so established as vital underpinnings in the development of properly diversified portfolios (i.e., proper asset allocation of investment portfolios) as to have revolutionized the way the vast majority of investment advisors and other financial fiduciaries have come to understand their responsibilities to their clients.

A comprehensive exploration of Modern Portfolio Theory and its key principles of proper asset allocation planning are beyond the scope of this web site. However, it is useful to understand three core ideas of Modern Portfolio Theory and these are discussed below. Finally, we will discuss why Index Funds are particularly useful investment instruments for utilization in the implementation of a proper asset allocation plan.

Core Ideas of Modern Portfolio Theory

1) Understanding Investment in Terms of Investment Class

2) Class Blending/ The Key Determinant of Investment Performance

3) A Proper Blending of Asset Classes Can Reduce Risk in a Portfolio

Understanding Investments In Terms of Investment Class

One key idea from Modern Portfolio Theory is the understanding that different investment instruments (e.g. bonds, stocks, commodities, cash equivalents) can be classified, or grouped, in accordance with common characteristics that reflect their underlying nature. Called asset classes, these classifications can be utilized to bring together a multitude of separate individual investment instruments (say various stocks) into the broad asset class known as stocks. Similarly a multitude of separate individual “cash equivalent” instruments (Certificates of Deposit, Money Market Funds, Treasury Bills, etc.) can be brought together to form the asset class known as “cash equivalents” or simply “cash”. Due to the commonalties of their inherent investment characteristics, investment advisors, portfolio managers, and individual investors can begin to think of investment portfolios not in terms of the individual holdings (say General Motors stock, or Disney stock, or the city of Weirton pollution control bonds, or a Bank of America certificate of deposit) but by classes of holdings (say stocks, bonds, cash). Further, relevant sub-classes can be developed, like international stocks versus domestic stocks, or growth stocks versus value stocks or large capitalization stocks versus small capitalization stocks and so-forth.

Each asset class so construed would have unique properties as compared to the other asset classes. The different asset classes would have measurable differences in performance in different types of economic conditions. The different asset classes would have measurable differences in patterns of volatility, the tendency to gain value or lose value in different types of economic conditions. And finally, and most importantly, there would be measurable correlations between asset classes in terms of the tendency of the differing asset classes to act similarly or differently in different types of economic conditions (an extremely important factor in portfolio construction as we will discuss below).

This class perspective lies at the heart of Modern Portfolio Theory and more practically, proper asset allocation planning. (See Types of Index Funds to gain a better perspective on the differing characteristics of the primary asset classes utilized in proper asset allocation planning).


Class Blending/ The Key Determinant of Investment Performance

Once you begin to look at particular investment instruments in terms of asset class, you begin to see that class is more vital to proper investment planning than the individual instruments in the portfolio. That is, the class of large capitalization growth domestic stocks, for example, is more key than any particular stocks, say Microsoft or Hewlett Packard that are particular examples of the specific class of which they are a part. As we like to say, “We see the forest, not the trees.” Why do we say that class (the forest) is more vital to proper investment planning than the individual investment instruments (the trees)? Because powerful academic research on the determinants of investment performance have demonstrated that the decision as to class allocation in a portfolio overwhelms any other aspect of investment decision-making (including individual investment selection) in determining portfolio outcomes.

Larry E. Swedroe in Rational Investing in Irrational Times summarizes the matter as follows:

“Several academic studies have come to the conclusion that asset allocation—how investments are allocated among various asset classes in a portfolio—determines the vast majority of not only returns but also the risks of a portfolio. A study by Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, “Determinants of Portfolio Returns”, demonstrated that ninety-four percent of returns result not from market timing or stock selection, but from “asset allocation” decisions.(1) In another study of thirty-one pension plans, representing $70 billion of total assets under management, Eugene Fama Jr. found that asset allocation determined over ninety-seven percent of returns.(2) And, finally, a study by Roger G. Ibbotson and Paul D. Kaplan, analyzing the ten-year performance of ninety-four balanced mutual funds and the five-year performance of fifty-eight pension plans, concluded that approximately one hundred percent of a portfolio’s absolute return is explained by asset allocation.(3) Whether the number is ninety-four or one hundred percent doesn’t really matter. The evidence is very clear that asset allocation determines the vast majority of the risk and reward of a portfolio.” (RIIIT, pgs. 123-124).

1. Financial Analysts Journal (July-August 1986).
2. Dimensional Fund Advisors.
3. Roger G. Ibbotson and Paul D. Kaplan, “Does Asset Allocation Policy Explain 40%, 90%, or 100%of Performance?”, Financial Analysts Journal (January-February 2000).

A Proper Blending of Asset Classes Can Reduce Risk in a Portfolio

Finally, and most importantly, Modern Portfolio Theory posits the following revolutionary understanding: If a portfolio is constructed of differing asset classes that have different patterns of performance i.e., that tend to move (both up and down) in ways that are inverse or poorly co-related to each other, then the overall volatility (i.e., risk) of a portfolio (its tendency for big gains or big losses) will be reduced with no negative impact on expectations for long-term performance of the portfolio.

In Dr. Markowitz’s words (as related in Donald B. Trone, William R. Allbright and Philip R. Taylor, The Management of Investment Decisions (1996), pg 72):

“[E]ffective diversification depends not only on the number of assets in a trust portfolio but also on the ways and degrees in which their responses to economic events tend to reinforce, cancel or neutralize one another. (4)

4. “Portfolio Selection”, Journal of Finance, March 1952

The authors of The Management of Investment Decisions then discuss Dr. Markowitz’s “effective diversification” principle as follows:

“At that time, all publications discussing preferred investment practices looked pretty much the same as the newspaper and magazine articles appealing to the retail investor today. That is, they harped on investment return and ignored risk. However, Dr. Markowitz recognized that the singular focus on return did not square with reality: “it occurred to me that I should consider risk as well as reward.” (TMOID, pg. 73).

The heart of proper asset allocation planning hinges on the core insights promulgated by Dr. Harry Markowitz, that is that the optimization of a portfolio lies in an understanding of the classes of investments that compose the portfolio and the blending of such classes of investments in a manner designed to reduce risk per increment of return or to increase return per increment of risk. This goal is furthered by the blending of asset classes that are imperfectly or negatively correlated with each other so that volatility is dampened while return is not.

A visual representation of this concept is as follows:

The authors of The Management of Investment Decisions perhaps put the matter most succinctly when they write as follows:

“Investors should understand there is only one way to increase the returns of their otherwise randomly diversified portfolios without a corresponding increase in portfolio risk: asset allocation, the only free lunch!” (TMOID, pg 74)

Index Funds and the Implementation of Proper Asset Allocation

Index Funds are by their very nature, class funds. That is, index funds are developed to re-produce the performance and risk characteristics of various asset classes. (See Types of Index Funds to gain a better perspective on the differing characteristics of the primary asset classes utilized in proper asset allocation planning). Unlike the typical mutual fund, which frequently strays or “drifts” from its stated investment objective (as managers attempt to exploit some perceived opportunity), Index Funds make no attempt to exploit some perceived opportunity and therefore stay true to the particular class it seeks to mirror. For example, a small capitalization index fund attempts to mirror the performance of a particular small capitalization index and stays true to that particular asset class. Even if, at any particular time, large capitalization stocks have been performing better than small capitalization stocks, the small capitalization index fund does not stray or drift from its objective. Index funds do not attempt to outwit the market. This is often not the case with mutual funds. Often, a fund with a small capitalization “objective” (or any other objective) will drift from that objective as the managers attempt to add value for their shareholders. (See Style Drift for a fuller discussion of this troublesome mutual fund phenomenon.)

Under Evidence, Costs, and What a Drag elsewhere on this web site, we discuss the failure of mutual funds to succeed at adding value in excess of the costs engendered in the attempt to do so. Here at Proper Asset Allocation, however, we are focussed not on the cost benefit of utilizing Index Funds in portfolio planning, but their functional superiority. Index Funds are functionally superior investment instruments because Index Funds are fundamentally pure, uncluttered building tools by which an Investor can accomplish two strategic portfolio planning goals:

1. An Investor (and their Investment Advisor) can structure portfolios reflecting the Investor’s unique capacity for risk, performance goals, and investment time horizon.

2. An Investor (and their Investment Advisor) can seek to “optimize” the Investor’s portfolio performance by blending of non-correlated asset classes (see the above discussion on the principles of Modern Portfolio Theory).

Let’s be clear: you don’t need to engage in proper asset allocation planning to benefit from Index Funds. Let’s say you just want to place your bet and take your chances. You can choose to put on your investment funds into say an Emerging Markets Fund (composed of a portfolio of stock or equity holdings that will mirror the return and volatility patterns of emerging stock markets as a whole, that is, stocks of countries that are just emerging into the industrial mainstream, like say Thailand or Indonesia). No diversification of asset class. A straight play. Make a lot money or lose a lot of money. In such instance, the election to invest in an Emerging Markets Index Fund should still be significantly superior to investing a mutual fund that actively attempts to add value. The reason: Costs should be dramatically lower when compared to actively managed funds that invest in the same high risk markets and there is little reason to believe that the substantial costs engendered by the activity of the “active” mutual fund manager will enhance returns in excess of those costs. In other words, the Index Fund would still be king. You don’t need to engage in proper asset allocation planning to derive benefit from utilizing Index Funds. However, when utilized in combination with proper asset allocation planning (along the lines discussed herein), the benefits of Index Funds are even greater. For in such instance, the Investors gains the double benefit of low cost, and class differentiated, building blocks with which to form the desired properly allocated portfolio.