Monday, June 17, 2013

Asset Allocation: The Largest Determinant of Returns, But Don’t Pay for Advice

Asset Allocation: The Largest Determinant of Returns, But Don’t Pay for Advice

The largest determinant of your investment returns comes from asset allocation: how much you put into stocks, bonds, and other assets.  Everything else, such as securities or manager selection, pales in comparison.  And on average, active manager selection actually detracts from returns.  For decades managers have been trying to figure out how to get paid for advising their clients about asset allocation.  As far as I can tell, managers don’t add value in the asset allocation process and most are not held accountable.

The manager’s thinking goes as follows.  If asset allocation is the most important investment decision, and money managers provide the service, then they should be able to earn an extra fee.  Typically, investors have resisted paying extra, and as we shall see, that is a good thing.  However, some managers have managed to bundle asset allocation into their service offering.  For the wealthier investor, asset allocation is thrown in as part of a flat fee, say 1%, that’s meant to include money management services and financial planning.  For the average retail investor, asset allocation can be imbedded in fund-of-mutual fund products (collections of mutual funds), for which the manager can collect an extra fee.
 
Reserving Capital (2010)
While asset allocation is pivotal to the returns you can expect to generate and the amount of risk you are likely to incur, there’s little evidence that money managers add any value.  Typically, money management firms have committees that ponder the proportion of capital that should be allocated to a wide variety of asset classes and sub-asset classes (e.g., growth or value equities, large or small cap stocks, corporate or high yield bonds).  They also have “proprietary” investment models that provide quantitative rationales for allocating capital.  Wild guesses tend to look predictive when they are carried out to a couple of decimal places in a spreadsheet.  Some of my most fruitful drawings came while listening to an impassioned discussion of the relative merits of allocating 5% or 10% to the emerging markets, or decreasing the weight in mortgage-backed securities.  

Believe it or not, the arguments can become quite heated as portfolio managers marshal a few well-chosen factoids along with strong opinions about the future direction of the various asset classes.  The problem, of course, is no one knows what’s going to happen in the future, so most of the tactical changes in asset allocations are merely guesses.  On some occasions, the changes are merely calculated business decisions because the managers can make more money putting clients into certain products.  There’s nothing better than the rarified air of an asset allocation discussion to hide the real business objective of steering more money into hedge funds or private equity.

So what’s an investor to do?  The balanced approach is the consensus asset allocation consisting of 60% stocks and 40% bonds.  If you are young or aggressive, you want to push your equity allocation toward 80%.  If you are old or conservative, you probably sleep better with 40% or less of your assets tied up in stocks.  Within stocks and bonds, you might divide things up into a few categories.  In equities you need to have most of your exposure to domestic, large cap stocks.  However, international and small company stocks deserve some representation.  In bonds, you want to vary the maturities a bit, and create exposure across different sectors of credit.  Generally speaking, you don’t want to mess with your asset allocation more than once a decade, unless there’s a big change in your life.  If your broker or financial advisor shows you a proposed allocation that is chopped into 15 or 20 small pieces, or advises you to allocate money in 2% or 3% increments (e.g., putting 2% in small cap value stocks), tell him or her to start over with a simpler plan or find someone else to advise you. 

In any event, try not to pay for the advice.  While asset allocation is critical to your future returns, there’s little evidence that complicated asset allocation processes or models do anything, except attempt to justify fees.  As in most matters of money management, simple is best.




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