The Overwhelming Importance of Asset Allocation

It’s fun to pick stocks. You buy a company because you think it’s an undiscovered gem or it’s going to grow like kudzu. Then you watch its daily performance, rooting for its price to go up as the rest of the world catches on to what you already recognized. It’s got all the excitement of a horserace.

But picking stocks, it turns out, is a sideshow.

What turns out to be most important is not which particular stocks you—or your investment advisor—pick, but rather to what degree you’re in or out of stocks. Or more precisely, how closely you hew to your asset allocation plan.

In a famous study, Brinson, Hood, and Beebower looked at the long-term investment performance of a group of pension funds, and attempted to attribute the variation in their performance to three factors: asset allocation, market timing (trying to get into or out of stocks at just the right times), and individual stock picking. The authors concluded that deviation from the funds’ asset allocation plan accounted for 93+% of the variation.

93%!

Picking stocks is fun. It gives you a horse to root for. But in the long run, it’s not nearly as important as picking the asset allocation that’s right for you, and sticking to the plan. Stock-picking is a sideshow. It’s the sizzle that sells the steak. But asset allocation is the steak that nourishes the body. That’s the main event.

And here’s the kicker. Selecting the right asset allocation is your job. Not your expensive investment advisor who gets paid for the other 7% of the results. It’s you! You’re a doctor or a plumber or a schoolteacher—something other than an investment professional. You can (and should) get guidance from your investment advisor as to the right asset allocation, given your age, financial circumstance, and psychological risk tolerance. But ultimately it’s your responsibility to tune the stock-bond knob. And nobody’s paying you anything to do that.

Now here’s another kicker. It turns out that selecting the “right” asset allocation is very hard. More on that in future posts. Much more.