Asset allocation: Why it matters
Picking investments that outperform seems like an obvious way to riches. But, as Marcia Pardoch will tell you, asset allocation mistakes can undo a lot of good investment work.
Meet identical twins Marcia and Jan Pardoch, distantly related to one of Australia’s wealthiest establishment families. A decade ago, they each inherited $500,000 from a childless uncle.
Marcia works at a major funds management business, running an international equities fund. She considers herself an expert in this asset class and decided to invest her entire inheritance in her own fund.
Jan is a musician who knows nothing about investing. She sought her father’s advice at the time, who recommended Jan split her inheritance into four even portions: Australian shares, International Shares, Australian property and Australian fixed interest.
|Australian Fixed Interest||5.63%||5.63%|
Jan didn’t get too clever with her investments and simply picked funds that delivered ‘benchmark’ returns*. You can see her results over the past ten years in Table 1.
Marcia’s prowess with international stocks has shone through for her clients and her own investments over the period: her fund returned 3.5% a year compared to the benchmark’s average annual loss of 1.03% (Table 2).
Marcia’s employer is ecstatic with the results. She has smashed the index by more than 4.5% per year (after expenses) and her employer has earned plenty of performance fees. Yet when Marcia compares the balance of her inheritance with that of her twin sister, she’s disappointed.
Despite all her stress, expertise and outperformance, her $500,000 inheritance is now worth $705,300. Over the same period, Jan’s identical inheritance has grown to $781,700. So Jan is better off by more than $75,000 and didn’t suffer the sleepless nights that her twin sister did (particularly during the GFC).
It all comes down to asset allocation – the process of deciding how you will spread your portfolio over different asset classes.
Despite Marcia’s investment success within her specialist asset class, it turned out to be the wrong one to be invested in over that decade (due largely to the strength of the Aussie dollar). In an earlier decade her 100% allocation to international equities might have turned out fantastically (with or without her outperformance) which, again, illustrates the importance of the asset class selection.
While the $125,000 Jan invested in international shares went backwards over the decade (she lost more than $12,000 in that asset class), she had good exposure to better-performing investments. Jan’s very basic asset allocation strategy was a more powerful driver of overall returns than Marcia’s exceptional outperformance. That’s a key message for those of us overseeing our own superannuation funds.
In this case, Jan’s was a static strategy – an upfront investment of 25% in each asset class – with no attempt to rebalance as, for instance, share prices rose and her allocations got out of whack. Her superior results to Marcia came about simply because she wasn’t overly exposed to the poorest performing asset class.
That’s all to the good. But one or two strategic decisions during the decade – for instance, shifting to a higher shares allocation in the wake of the GFC – might have seen her returns exceed Marcia’s by an even greater margin.
The story of Jan and Marcia provides a colourful insight into what some important, but rather dry, academic studies have shown about the topic of asset allocation.
Asset allocation on the map
In 1986 asset allocation pioneer Gary Brinson and two colleagues captured the investment community’s attention when they published a study of 91 large pension funds from 1974 to 1983.
Their aim was to unpick the results and determine whether they were driven more by asset allocation or individual investment selection. To produce their findings, they replaced a fund’s individual stock, bond and cash investments with broad market indices reflecting the manager's asset allocation choice.
In other words, if a fund had 12% invested in a portfolio of shares and 15% in a portfolio of bonds, they would be replaced with a 12% weighting in a broader index like the S&P 500 and a 15% weighting in a bond index . This allowed a comparison of how much value was being added by the selection of individual shares or bonds and how much from the decision to allocate 12% to shares and 15% to bonds in the first place. What do you think they found?
Incredibly, the returns on the 'comparison portfolio' were higher than the actual returns. In other words, the fund managers asset allocation decisions explained more than 100% of their returns. In this study the individual stock and bond selections, on average, contributed negative performance.
This comment wasn't made to pick on fund managers. Whether their individual selections contributed positively or negatively wasn't the point. The key take-away is that their asset allocation decisions were, by far and away, the main driver of their end result.
Further studies have confirmed the general point that asset allocation is a crucial factor in determining returns. Not that you’d know it from reading the business pages and lift-outs in the mainstream media. Stories of individual stocks soaring or plummeting make better headlines than sober warnings about, essentially, not putting all of your eggs in the one (asset class) basket.
To us, making sensible asset allocation decisions is one of the most important, yet unheralded, aspects of actively managing your own superannuation fund. It mightn’t sell newspapers but it will drive a significant portion of your returns over the long term.
The financial future for most of us will be a function of a few basic elements. Asset allocation is one of the more important ones. Another is allowing for the interaction between your human capital and your financial capital. This should influence your asset allocation decisions, too, and that’s what we’ll be tackling in our next article.
Want access to our latest research and new buy ideas?
Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.Sign up for free
Join the Conversation...
There are comments posted so far.