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Why Asset Allocation is so important.

“We know that the real challenge in portfolio management is not how to increase returns, but how to manage risk.” – Charlie Ellis.

Put your eggs in different baskets.

‘Don’t put all your eggs in one basket’ is age-old and sage advice. Putting all eggs in one basket is risky. Intuitively we know that diversification reduces the risk of any single investment or income stream.

In 1952, Harry Markowitz wrote his ground breaking paper which we now know as the birth of modern portfolio theory. One of the assumptions Markowitz made was that investors like returns but dislike risk more. Given the prospect of losing a dollar or winning a dollar, investors would much rather not lose. Think about it. Losing hurts more than winning feels good. Investors are risk averse.

If risk is more important than return, then investors ought to focus on risk. Still, we focus on returns. (Because risk is hard to understand … and don’t we all avoid something that is hard(er))?

Markowitz focused on risk by combining investments into a portfolio. By doing so, his portfolio performance was the average return of the individual asset returns. But – and this is the key – because individual asset returns varied (i.e. not in sync), the overall portfolio returns were more stable. Lower returns of some investments were offset by higher returns on other investments. Portfolio return volatility or risk was reduced. And that’s how most Individual investors define risk … volatility.

In addition to reducing volatility risk, Markowitz found that diversification across investments that had different characteristics and return patterns that occur at different times and under different economic conditions, this also increased return consistency. This too is intuitive. Broader diversification means participating in more opportunities for return while moderating the impact of a single devastating loss. Income from many sources means a more stable portfolio of returns. And performance consistency means that returns compound faster. (Who said … ‘Better a steady dime than an occasional dollar’)?

Thus was borne the idea of putting eggs in different baskets – allocating assets – as a way to moderate the risk(s) from any single investment. This fundamental idea – asset allocation reduces risk and increases returns – is the foundation for investment portfolio management. It changes the focus for long-term investors toward seeking the least risk approach (in order to reach financial objectives) and away from maximizing returns only without regard to risk thereby focusing on what is most important and controllable – asset allocation.

Just how important is asset allocation?

A cornerstone study by Brinson, Hood and Beebower found that over 90% of the performance of an Institutional portfolio could be attributed to how assets were allocated. The overwhelming majority of contribution to investment portfolio performance comes from asset allocation (the large wedge in the asset allocation pie). It is the predominant factor in both managing risk and determining returns.

Both the investment theory and the practical application are solid and enduring. (Since Markowitz’s thesis, we’ve had 60 years of practice and proof that asset allocation works). The evidence is compelling. If you do nothing else, do asset allocation. For an Individual investor, this might be as simple as buying a balanced fund.

Next time?

Whose job is Asset Allocation?

Doug Cronk, CFA is Manager, Investments for a Canadian Pension fund.

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