Asset Allocation: The 90% Question

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Asset Allocation: The 90% Question
by James D. Peterson, Ph.D., Vice President, Investment Manager Research, Schwab Center for Financial Research

Have you heard the expression that asset allocation explains more than 90% of the variability in portfolio returns? If not, you’re bound to hear it eventually, since it’s one of the most commonly quoted results in the investment industry. Let’s take a look at what this figure really means.

In general, asset allocation refers to the mix of stocks, bonds and cash in your portfolio. But there are really two types of asset allocation strategies.

Strategic asset allocation. When people cite the 90% variability figure, they’re talking about strategic asset allocation: your long-term, fixed allocation to stocks, bonds and cash, based on your goals and tolerance for risk. Sometimes called investment policy, it shouldn’t change just because the market moves up or down; it should only change when your personal circumstances change.
Tactical asset allocation. This is the process of making short-term adjustments to your strategic, or long-term, allocation. These temporary shifts typically occur in response to current economic or market conditions, whereas current conditions don’t play a central role in determining strategic allocation. We believe that these temporary shifts should typically be no more than five to 10 percentage points above or below your strategic weights.

Debunking myths
Some people think that the 90% result means that asset allocation will explain 90% of any portfolio’s return—no matter the constituents of that portfolio. But that’s not necessarily the case. In fact, the 90% result was based on a sample of highly diversified pension funds.

Individual investors' portfolios typically aren't as well diversified as pension funds because of the smaller dollar amounts involved. Asset allocation isn’t going to help if you only hold one stock in your portfolio and that stock turns out to be an Enron! If your portfolio is poorly diversified, asset allocation will explain only a small percentage of the volatility in returns—maybe as little as 10% to 20%. In fact, there are even many mutual funds where the number is less than 50%.

Another myth is that since strategic asset allocation explains a high percentage of the variability in returns, tactical asset allocation and security selection are unimportant. How high is 90%? It sounds like a lot because it seems so close to 100%, but is it? In an article titled “The 93.6% Question of Financial Advisors,” author Meir Statman, constructed a hypothetical example where an investor was perfect at tactical asset allocation. That is, the investor was consistently able to pick, with perfect foresight, the best asset class for that year, and allocated their entire portfolio to it.

Using this hypothetical example, Statman showed that strategic asset allocation explains about 89% of that portfolio’s variability—and 89% seems like a high number. Does that mean that the hypothetical investor’s tactical foresight added little value? On the contrary, the hypothetical portfolio earned more than the benchmark each and every year by an average of about 8%.

Opportunity for enhancement
Obviously, this is an extreme example. No one has perfect foresight, and you shouldn’t take tactical asset allocation to such lengths. But it illustrates the point, which is that even if strategic asset allocation explains 90% of a portfolio’s variability, there’s still plenty of opportunity to enhance return through tactical allocation and security selection. Of course, these activities can detract from return, too.

How is it that tactical asset allocation and security selection can affect return when such a large part of variability is explained by strategic allocation? Because explaining variability is not the same as explaining return or return differences across investments.

Consider two hypothetical S&P 500® index funds; the only difference is that one has a higher expense ratio than the other. With the exception of minor tracking deviations, asset allocation will explain 100% of the return variation over time for each fund. When the S&P 500 goes up, each fund goes up, and vice versa. However, asset allocation won't explain any of the performance difference across the two funds. In other words, it won't explain why one fund had a higher return than the other. Instead, the difference in performance across funds in this simple example is entirely explained by the difference in expense ratios.

Outperform the index?
Of course, return can differ across investments for other reasons, too. For example, suppose that instead of buying a passively managed S&P 500 index fund, you construct a broadly diversified portfolio of stocks from a subset of the stocks that make up the S&P 500 index. In addition, suppose you’re good at picking stocks, so your portfolio outperforms the index. In that case the fact that you hold a broadly diversified portfolio of individual stocks from the S&P 500 universe means that strategic asset allocation will explain a high percentage of the variation in your return.

But if you’re really good at picking stocks, you could outperform the index by several percentage points. Of course, if you’re not good at selecting stocks you could underperform by several percentage points, too. The point of these examples is that security selection is vitally important, even in the extreme case where asset allocation explains 100% of the variability in returns!

To sum up, selecting a strategic asset allocation is a critical decision because it involves determining your goals and risk tolerance. But investment management doesn’t stop with that decision—it’s also crucial you diversify investments within asset classes.

Statman, Meir. “The 93.6% Question of Financial Advisors,” The Journal of Investing, NY, NY, 2000.

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The Schwab Center for Investment Research is a division of Charles Schwab & Co., Inc.

The information presented herein is general in nature and is for informational purposes only. It does not consider your particular investment objectives or financial situation and does not make personalized recommendations. This information should not be construed as an offer to sell or a solicitation of an offer to buy any security. The investment strategies and the securities shown may not be suitable for you. Individuals should contact their own professional tax and investment advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based upon this information. We believe the information provided is reliable, but Charles Schwab & Co., Inc. ("Schwab") and its affiliates do not guarantee its accuracy, timeliness, or completeness. Any opinions expressed herein are subject to change without notice.

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