In 1986, Brinson, Hood, and Beebower determined that asset allocation is responsible for over 93% of the variation of portfolio performance. Though this might be true in a theoretical world without expenses and emotions, we’ve all seen the data with the gap between investor return and fund return. That’s because clients fiddle with asset allocation, chasing performance. Unfortunately, there is also significant data to show that advisors, as a whole, also have this problem.
Over the 15-year period that ended on Dec. 31, 2013, stocks and bonds had similar returns, with annual returns for U.S. stocks at 5.38%; international stocks, 5.15%; and bonds 5%. Intuition, combined with the benefit of hindsight, tells us that a 100% U.S. stock portfolio would have outperformed any combination since the other asset classes had lower returns.
In investing, however, intuition is often wrong. In actuality, any combination of the three funds outperformed the highest performing single fund, as long as one was consistent with the allocation. In this case, rebalancing was done twice annually, every June 30 and Dec. 31. Thus, being consistent with the allocation was actually more important than picking the right one in the first place.
Rebalancing, while simple, isn’t always easy. Maintaining a consistent asset allocation would have required buying stocks after the Internet and real estate bubbles popped, and selling as stocks surged. Yet, such consistency yields dollar-weighted returns greater than the fund return because it means buying when others are selling and vice versa.
Clearly, the odds are that stocks will outperform bonds over the next 15 years. But the importance of having a consistent asset allocation is likely to continue to provide returns higher than the funds themselves, rather than the reverse.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.
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