The importance of asset allocation

The article “The Importance of Asset Allocation” by Roger G. Ibbotson, examines the role of asset allocation in determining portfolio performance. The key points are:

The seminal work by Brinson, Hood, and Beebower (BHB) in 1986 claimed that asset allocation policy explains over 90% of the variation in fund performance. However, this result largely reflects the influence of general market movements rather than specific asset allocation decisions.

Ibbotson and Kaplan (2000) found that asset allocation determines 100% of the return in a mathematical sense, but this includes both market returns and the effects of asset allocation. Active management, which involves timing, security selection, and fees, contributes to the remaining performance but averages out to zero over time due to market efficiency.

Asset Allocation

Subsequent studies show that asset allocation policy explains approximately 40% to 75% of the variance in fund returns, depending on the time period and methodology. Most of the performance variation is attributed to general market movement, not just asset allocation.

Many investors mistakenly believe that the high percentage applies to the return level rather than the variation of returns. Results are often misinterpreted, leading to confusion about the impact of asset allocation.

Modern research indicates that both asset allocation and active management have similar impacts on performance. General market trends account for a significant portion of return variability, and the specific impact of asset allocation is smaller than previously thought.

There is a connection between asset allocation and active management. Strategic asset allocation is key part of any portfolio construction. Active management is also important, through rebalancing, stock selection, timing you are sticking to initial asset allocation.

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