Capital markets are composed of different types of asset classes. Asset allocation involves dividing an investment portfolio among different asset classes based on an investor’s financial requirements. The right mix of asset classes in a portfolio provides an investor with the highest probability of meeting their financial goals.
90% of the variation in portfolio return is explained by asset allocation decisions.Each asset class selected has a long-term expected return over inflation, known as the ‘real’ return. A diversified portfolio will include U.S. and foreign stocks, real estate (REITs), as well as different bond components. See our 30-Year Financial Forecast for a sampling of asset classes that meet the above criteria.
Asset allocation is the most important investment decision an investor will make in their portfolio because it explains most of the risk and return. Not surprising, this view is not without controversy. Some advisors believe that having the right active management style explains most portfolio performance. Academic researchers have looked closely at both sides.
In 1986, Gary Brinson, L. Randolph Hood and Gilbert Beebower analyzed the returns of 91 large U.S. pension plans between 1974 and 1983. They concluded that asset allocation explained 90% of the variance in returns. That conclusion was confirmed by the same authors in 1991 after analyzing a larger database of returns. Roger Ibbotson and Paul Kaplan published a landmark study in 2001 titled “Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?” The report confirmed that more than 90% of the variation in portfolio return is explained by asset allocation decisions. It is not the selection of individual stocks or bonds driving performance. It is the asset allocation that makes the difference in the long-term.
How Asset Classes Work Together
Stocks and bonds are the two major categories used in portfolio diversification. The amount that an investor should have in stocks and bonds is based on two factors. First, the allocation is based on the expected return that an investor requires to meet their financial objective, and second, it is based on the amount of investment risk that a person can accept. A successful allocation is one that achieves an investor’s financial goals without so much volatility that it causes the investor to make behavioral mistakes.
Asset allocation analysis should include a correlation study between investment types. Correlation analysis shows how the price of one investment has historically moved in relation to the price of another. If two asset classes moved in the same direction at the same time they had positive correlation. If the returns had moved in different directions at the same time, they had negative correlation.
Correlation is not a fixed number. It changes over time and in unpredictable ways. It would be ideal if two asset classes had positive real returns expectations and consistent negative return correlation with each other. Unfortunately, there are no such pairs of investments. A rolling correlation study shows that the correlation between any two asset classes tends to shift over time and in an unpredictable way. Based on past data, we can only loosely predict what the correlation between two asset classes might look like.