Asset Allocation
I think it was George Bernard Shaw, the Irish playwright and 1925 winner of the Nobel prize for literature, who once said that people who do not know the laws of probability were not fit to run for government. I don't think he was alluding to any special mathematical ability. Rather, I believe he felt it was of utmost importance that any person charged with the responsibility of looking after the resources of a country should be astute enough to make well calculated guesses in a world of uncertainty. The same must surely be true of the financial adviser charged with the responsibility of looking after the assets and financial well-being of his client. But how does one deal with uncertainty, especially uncertainty of the extreme kind? And how does one make, as it were, calculated guesses?
According to an influential study conducted by money managers Gary Brinson and Brian Singer and consultant Gil BeeBower over a ten year period from 1974 to 1983, dubbed the Brinson Study, stock selection and market timing do not matter nearly as much as how you mix the building blocks of your investment portfolio. Asset allocation determines more than 90% of the returns on your investment, as the Study revealed, with the specific stocks you choose and market timing accounting for the rest. So the key to a winning investment strategy is not so much to choose the right stock or fund but to choose the right asset mix and then to stick to it. But sticking to a long term investment strategy is not easy especially in light of the turbulence that we have seen in recent years.
In the 1994 to 2003 period, the Asian Contagion, Hedge Fund Crisis, and dotcom Crash occurred. The period during which the Brinson study was done, 1974 to 1983, was relatively stable. So is the Study relevant in today's turbulent environment?
The Brinson Study Revisited
When we compare the S&P 500 Index during the 3 periods of 1974 to 1983, 1984 to 1993, and 1994 to 2003, the returns during those periods bear no resemblance (visually, as well as, in terms of correlation) to each other. It is pertinent, therefore, to ask if the Brinson Study done during the relatively stable period of 1974 to 1983 holds for other less stable periods as well.
Over the last 30 years, an efficient portfolio calculated using the Markowitz mean-variance theorem would have suggested a mix of 61.9% in gold (and other assets) and 38.1% in the S&P500 to achieve a portfolio with a mean return of 10.2% and volatility of 16.5%.
Over the last 20 years, the suggested efficient mix was 57.6% in gold (and other assets) and 42.4% in the S&P500 to achieve a portfolio with mean return 10.2% and volatility 17.7%
And over the last 10 years, the suggested mix was 60.8% in gold (and other assets) and 39.2% in the S&P500 to achieve a portfolio with mean return 10.2% and volatility 19.1%.
The proportion of S&P500 to put into the portfolio hovered between 38.1% and 42.4%. And despite the S&P500's mean return going down over the 3 periods from 9.6% ( over the last 30 years ) to 7.7% ( last 20 years ) to 2.1% ( last 10 years ), the portfolio mean return was maintained at 10.2% with its overall volatility increasing less than 3 percentage points.
Doing a rigorous evaluation of Brinson's Study is beyond the scope of this article but did you know that the Study was not so much as to suggest asset allocation but to discourage market timing and stock picking. You see the Brinson Study had a more interesting result than that asset allocation explained 90% of investment return. The Study showed a more important fact --- that market timing and stock picking actually decreased portfolio return by -1.1%. In other words, actively allocate along the way and chances are you will mess up your portfolio to the detriment of your long term goals.
The observations over the 3 periods in the preceding paragraphs seem to support this notion. The S&P500 with its decreasing return over the years would have led market timers and stock pickers to sell in order to stop loss. Those following the long term asset allocation strategy would have to buy in when the S&P500 was down in order to maintain the proportion of this asset in the suggested efficient mix.
It's Essentially Volatility
It would appear then that volatility, even extreme volatility within its expected limits, is part of the essence of a long-term portfolio plan which in turn is a function of your appetite for risk. The fear of losing out because you did not act on the advice of some cable channel guru will likely tempt you to call your broker or agent the next day to cash out while you can.
Volatility plus the effect of compounding long term annualized returns makes it hard to get a fix on how much you will (or will not) have in the future and the opportunity costs can be disastrous. A portfolio that is diversified has a risk return profile that captures a target return to achieve long term goals while taking into consideration one's appetite for risk. If your 10 year investment horizon ends tomorrow and markets crashed yesterday, it does not mean asset allocation was wrong. Low risk does not mean no risk. The prudent investor would have minimized this risk along the way making it less probable for such a scenario to ensnare him.
Rebalancing a portfolio so that it keeps true to the asset allocation you originally established, or the volatility you are willing to accept, will ensure you have the greatest chance of coming out on top of your life goals. By unloading an asset class that has enjoyed a nice rise, you managed to sell high, although not necessarily at the highest high. Similarly, buying into a declining market will ensure you own sufficient amounts to boost your overall portfolio return when the asset class ultimately recovers.
So is the Brinson Study still applicable in these turbulent times?
My calculated guess... is a resounding yes.
I think it was George Bernard Shaw, the Irish playwright and 1925 winner of the Nobel prize for literature, who once said that people who do not know the laws of probability were not fit to run for government. I don't think he was alluding to any special mathematical ability. Rather, I believe he felt it was of utmost importance that any person charged with the responsibility of looking after the resources of a country should be astute enough to make well calculated guesses in a world of uncertainty. The same must surely be true of the financial adviser charged with the responsibility of looking after the assets and financial well-being of his client. But how does one deal with uncertainty, especially uncertainty of the extreme kind? And how does one make, as it were, calculated guesses?
According to an influential study conducted by money managers Gary Brinson and Brian Singer and consultant Gil BeeBower over a ten year period from 1974 to 1983, dubbed the Brinson Study, stock selection and market timing do not matter nearly as much as how you mix the building blocks of your investment portfolio. Asset allocation determines more than 90% of the returns on your investment, as the Study revealed, with the specific stocks you choose and market timing accounting for the rest. So the key to a winning investment strategy is not so much to choose the right stock or fund but to choose the right asset mix and then to stick to it. But sticking to a long term investment strategy is not easy especially in light of the turbulence that we have seen in recent years.
In the 1994 to 2003 period, the Asian Contagion, Hedge Fund Crisis, and dotcom Crash occurred. The period during which the Brinson study was done, 1974 to 1983, was relatively stable. So is the Study relevant in today's turbulent environment?
The Brinson Study Revisited
When we compare the S&P 500 Index during the 3 periods of 1974 to 1983, 1984 to 1993, and 1994 to 2003, the returns during those periods bear no resemblance (visually, as well as, in terms of correlation) to each other. It is pertinent, therefore, to ask if the Brinson Study done during the relatively stable period of 1974 to 1983 holds for other less stable periods as well.
Over the last 30 years, an efficient portfolio calculated using the Markowitz mean-variance theorem would have suggested a mix of 61.9% in gold (and other assets) and 38.1% in the S&P500 to achieve a portfolio with a mean return of 10.2% and volatility of 16.5%.
Over the last 20 years, the suggested efficient mix was 57.6% in gold (and other assets) and 42.4% in the S&P500 to achieve a portfolio with mean return 10.2% and volatility 17.7%
And over the last 10 years, the suggested mix was 60.8% in gold (and other assets) and 39.2% in the S&P500 to achieve a portfolio with mean return 10.2% and volatility 19.1%.
The proportion of S&P500 to put into the portfolio hovered between 38.1% and 42.4%. And despite the S&P500's mean return going down over the 3 periods from 9.6% ( over the last 30 years ) to 7.7% ( last 20 years ) to 2.1% ( last 10 years ), the portfolio mean return was maintained at 10.2% with its overall volatility increasing less than 3 percentage points.
Doing a rigorous evaluation of Brinson's Study is beyond the scope of this article but did you know that the Study was not so much as to suggest asset allocation but to discourage market timing and stock picking. You see the Brinson Study had a more interesting result than that asset allocation explained 90% of investment return. The Study showed a more important fact --- that market timing and stock picking actually decreased portfolio return by -1.1%. In other words, actively allocate along the way and chances are you will mess up your portfolio to the detriment of your long term goals.
The observations over the 3 periods in the preceding paragraphs seem to support this notion. The S&P500 with its decreasing return over the years would have led market timers and stock pickers to sell in order to stop loss. Those following the long term asset allocation strategy would have to buy in when the S&P500 was down in order to maintain the proportion of this asset in the suggested efficient mix.
It's Essentially Volatility
It would appear then that volatility, even extreme volatility within its expected limits, is part of the essence of a long-term portfolio plan which in turn is a function of your appetite for risk. The fear of losing out because you did not act on the advice of some cable channel guru will likely tempt you to call your broker or agent the next day to cash out while you can.
Volatility plus the effect of compounding long term annualized returns makes it hard to get a fix on how much you will (or will not) have in the future and the opportunity costs can be disastrous. A portfolio that is diversified has a risk return profile that captures a target return to achieve long term goals while taking into consideration one's appetite for risk. If your 10 year investment horizon ends tomorrow and markets crashed yesterday, it does not mean asset allocation was wrong. Low risk does not mean no risk. The prudent investor would have minimized this risk along the way making it less probable for such a scenario to ensnare him.
Rebalancing a portfolio so that it keeps true to the asset allocation you originally established, or the volatility you are willing to accept, will ensure you have the greatest chance of coming out on top of your life goals. By unloading an asset class that has enjoyed a nice rise, you managed to sell high, although not necessarily at the highest high. Similarly, buying into a declining market will ensure you own sufficient amounts to boost your overall portfolio return when the asset class ultimately recovers.
So is the Brinson Study still applicable in these turbulent times?
My calculated guess... is a resounding yes.
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