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Asset Allocation

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Asset allocation refers to the division of one's investment portfolio across the various asset classes.  At the highest level, this refers to a split between stocks and bonds.  Many more finely defined sub-asset allocations are also common.  Also, see Modern Portfolio Theory

Gary P. Brinson, L. Randolph Hood, and Gilbert P. Beebower, "Determinants of Portfolio Performance," Financial Analysts Journal, July/August 1986, pp. 39-44. This was the paper which revolutionized portfolio construction by emphasizing the importance of asset allocation.  It found that, on average, 93.6% of the total return variation of the pension funds studied over time was due solely to asset allocation.  Further, it found that active management resulted in an annual reduction of 1.1 percentage points in total returns.

Gary P. Brinson, Brian D. Singer, and Gilbert P. Beebower, "Determinants of Portfolio Performance II: An Update," Financial Analysts Journal, May/June 1991, pp. 40-48. "Clearly, the contribution of active management [which was found to be somewhat negative] is not statistically different from zero."  An update of their previous work, with similar conclusions.

John C. Bogle, "The Riddle of Performance Attribution: Who's in Charge Here — Asset Allocation or Cost?," a speech presented before the Financial Analysts Seminar Sponsored by the Association for Investment Management and Research At Northwestern University, Evanston, Illinois July 20, 1997. Vanguard's founder concludes that, while asset allocation is very important, controlling costs is also very important.

Wolfgang Drobetz and Friederike Köhler, "The Contribution of Asset Allocation Policy to Portfolio Performance," WWZ/Department of Finance Working Paper No 2/02 (115kb).  "... active management not only failed to add value above the policy benchmarks [but] it destroyed a significant portion of investors' value."  This paper concludes that asset allocation accounts for about 134 percent of the level of portfolio performance (implying that active management accounts for about minus 25%).

Eugene F. Fama and G. William Schwert, "Asset Returns and Inflation," Journal of Financial Economics, November 1978, pp. 115-146 (1.49mb).  For a smaller file version, see here (749kb).  This paper studies the relative efficacy of various asset classes as inflation hedges.  It finds that treasury bonds are a complete hedge against expected inflation.  It also finds that private residential real estate is a complete hedge against both expected and unexpected inflation.

Jeffrey T. Hoernemann, Dean A. Junkans, and Carmen M. Zarate, "Strategic Asset Allocation and Other Determinants of Portfolio Returns," Journal of Wealth Management, Winter 2005, pp. 26-38. This study reviews and revises the Brinson studies above.  This study concludes that strategic asset allocation only explains about 77.5% of the variability of portfolio returns, not 90+% as suggested by Brinson et. al.

Roger G. Ibbotson and Paul D. Kaplan, "Does Asset Allocation Policy Explain 40, 90, or 100% of Performance?," Ibbotson Associates (97kb). Also hereThe full article appeared in Financial Analysts Journal, January/February 2000 (244kb). An analysis of criticisms of the two "Determinants of Portfolio Performance" papers.

Scott L. Lummer and Mark W. Riepe, "The Role of Asset Allocation in Portfolio Management," Ibbotson Associates (40kb).  Also hereThis paper also appeared in Global Asset Allocation: Techniques for Optimizing Portfolio Management (John Wiley & Sons, 1994).

Paul A. Samuelson, "The Long-Term Case for Equities: and how it can be oversold," Journal of Portfolio Management, Fall 1994, pp. 15-24. This paper, written by a Nobel prize winner, warns against market timing, warns against active management, and generally supports the prudence of strategic asset allocation.

Paul A. Samuelson, "Asset allocation could be dangerous to your health: Pitfalls in across-time diversification," Journal of Portfolio Management, Spring 1990, pp. 5-8. This paper, written by a Nobel prize winner, warns against tactical asset allocation (and is consistent with the prudence of strategic asset allocation).

Steve Strongin and Melanie Petsch, "Protecting A Portfolio Against Inflation Risk," Investment Policy, July/August 1997, pp. 63-82 (439kb). An excellent discussion of how to hedge against various types of inflation risk.  It suggests that international diversification, inflation-indexed bonds, and commodities are the best hedges against inflation.

Ronald J. Surz, Dale Stevens, and Mark Wimer, , "The Importance of Investment Policy," Journal of Investing, Winter 1999, pp. 80-85. "We find that, on average, policy [a.k.a., asset allocation] explains approximately 100% of investment returns. If a manager succeeds in adding value, this can drop to as low as 85% when risk is not incorporated, and even to 75% on a risk-adjusted basis. If the manager fails to add value, policy can explain as much as 135% of return unadjusted for risk, or 165% risk-adjusted; the difference between these percentages and 100% is explained by manager value reduced through market timing, selection, and/or costs.  In other words, if a manager neither adds nor reduces value, policy explains 100% of performance."

Yesim Tokat, "The Asset Allocation Debate: Provocative Questions, Enduring Realities," Investment Research and Counseling /ANALYSIS, April 2005. A summary of the issues.  "Unless there is a strong belief in the ability to select active managers who will deliver higher risk-adjusted net returns, investors’ focus should be on the asset allocation choice and its implementation using broadly diversified, low-cost portfolios with limited market-timing."

Yesim Tokat, Nelson Wicas, and Francis M. Kinniry, "The Asset Allocation Debate: A Review and Reconciliation," Journal of Financial Planning, October 2006, pp. 52-63. A summary of the issues.  "Unless there is a strong belief in the ability to select active managers who will deliver higher risk-adjusted net returns, investors’ focus should be on the asset allocation choice and its implementation using broadly diversified, low-cost portfolios with limited market-timing."

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