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Asset Allocation & Generally Accepted Investment Principles

In addition to whatever you own, you have been given $10,000. You are now asked to choose between:
A. A sure gain of $5000
B. A 50% change to gain $10,000 and a 50% chance to gain nothing.

     Asset allocation is generally the primary determinant of both risk and return in most portfolios. Asset classes can be classified in broad terms like stocks, real estate, bonds, and cash, and they can be subdivided further into large-cap and small-cap, value and growth, international, and combinations of each. Bonds can be subdivided into short, intermediate, and long term, tax-free, high-yield, convertible, and international classifications.

     In real estate, many say you should focus on "Location, Location, Location," but you can just as easily argue that for broader investment analysis you should focus on "asset allocation, asset allocation, asset allocation.” Numerous studies have concluded that the percentage distribution of financial assets has accounted for most of the variability of portfolio return and risk, while market timing and security selection typically account for a smaller percentage. There have been some complex and detailed debates about the studies and their implications, which I will summarize below, but given that studies have also consistently shown that market timing and security selection on average subtract from performance, asset allocation is critical.

     Asset allocation should be consistent with an investor’s goals, constraints, and time horizon. The goal of asset allocation is to achieve the highest return for the acceptable level of risk, or alternatively the lowest risk for a needed rate of return. By combining assets with different characteristics in a portfolio, an investor can often achieve higher returns with lower risk over the long term. Adding high risk asset classes and investments to a portfolio may seem risky, but it’s common for the net effect to be both increased returns and lower risk for the portfolio. As an example, while international stocks may be riskier than U.S. stocks to an American investor, adding international equities to a portfolio of U.S. stocks actually usually lowers the risk of the portfolio because the assets don't move together all the time. That is, sometimes when U.S. stocks go up, international stocks go down and vice versa. The net effect is a portfolio that has less risk because it fluctuates in value less.

     A problem with mutual funds and managers that shift asset classes is that they alter the asset allocation for any investor in the fund. This is one reason some choose to use index funds since index funds do not shift asset allocation. Specific target allocations (for example 60/40 stocks/bonds) can be viewed as a starting point. It can be useful to establish asset allocation ranges since over time, fluctuations in value and income will alter asset allocations, which can create a need to rebalance and review goals and constraints.

     There are many types of asset allocation funds that intend to eliminate the need for investors to choose their own asset allocation. Some of these funds often attempt to provide investors with better returns through actively purchasing undervalued assets classes and under weighting overvalued asset classes. Most of these funds combine active market timing and asset allocation. However studies have found that if you expect to outperform the market using these funds you are likely to be disappointed. The broad market indexes tend to significantly outperformed equity funds in aggregate net of costs, which have in turn tend to outperform asset allocation funds (since they are not fully invested in equities), which tend to outperform bonds and cash.

     More recently target date and life cycle fund usage has grown dramatically and they are particularly relevant for retirement funds. Those funds usually reduce risk gradually over time by reducing the percentage of risky assets, but tend not to engage in market timing with riskier assets. There may be differences in asset allocation for funds among fund companies with similar target dates, but each funds asset allocation tends to be relatively stable along a so-called glide path.1

     Many researchers have studied funds to determine what factors account for variations in performance. The most frequently cited study was by Gary Brinson, Brian Singer, and Gilbert Beebower. In "Determinants of Portfolio Performance II: An Update"2 the authors assessed the impact of passive (benchmark) and active asset allocations and security selection on 82 large pension plans over the 1977-87 period and found that on average, benchmark asset allocation (allocation policy) explained 91.5% of the variation in quarterly returns. In other words, the decision to invest in asset classes (stocks, bonds, etc.) was much more important than the selection of individual securities in the sample.

     The predecessor study was titled "Determinants of Portfolio Performance."3 That study looked at the returns of 91 large pension funds from 1974 to 1983 and found that on average 93.6% of the total variation in actual plan results could be attributed to investment policy. Less than 5% of the returns were determined by security selection.

     William Jahnke4 and John Nuttall5 are two of the many that have written extensively to criticize the way many have interpreted and reported the results of those studies. Those interested in learning more about those debates can read the actual studies and commentaries, but for most investors the implication is that the primary focus of the investment process should be on asset allocation.

     Roger Ibbotson and Paul Kaplan are among the many that have attempted to clarify the debate and their commentary was published in a Financial Analyst Journal article in 2000.6 They studied balanced funds and pension fund data and concluded that 90% of variability in returns is explained by policy, 40% of variation in returns among funds is explained by policy, and 100% of the "return level" is explained by policy return level. Vanguard has also published several commentaries and they concluded "Asset allocation remains the primary determinant of returns in portfolios made up of index or broadly diversified funds with limited market-timing."7

     The question at the start of the chapter is a slightly modified version (by a factor of 10) of the question asked by Daniel Kahneman and Amos Tversky in their 1979 paper.8 In the question at the start of the chapter, 84% chose A. However, the question from Chapter 5 is phrased differently, but is identical in terms of net cash to the subject. 69% chose B in that question, which tells us that people were heavily influenced by how the question was framed even though the net results were the same.

Generally Accepted Investment Principles

Individuals who invest their own money can turn to many sources for investment advice -- such as books, magazines, newspapers, mutual fund companies, and web sites. In an article entitled "Personal Investing: Advice, Theory, and Evidence" that appeared in the November/December 1997 issue of the Financial Analysts Journal, Zvi Bodie and Dwight Crane examined whether individual investors tend to follow the advice offered in these sources. Bodie and Crane summarized the advice in a set of guidelines which they called "generally accepted investment principles."

     The authors noted that all the sources of investment advice that they consulted recognize that the optimal asset mix for a particular household might differ from the general mix they recommend because of the special circumstances or risk preferences of the given household. Time horizon, risk tolerance, income stability, and other factors influence asset allocation. Some commentators find the age minus 100 in stocks rule of thumb problematic, especially for older investors. I discussed this with Professor Bodie and he pointed out that he does not recommend following the rule given the complexities and other factors. The point of the article was summarizing the conventional view to further the discussion, rather than making a specific asset allocation recommendation.

     In the study, the authors analyzed data from questionnaires sent to TIAA-CREF members. 4,622 questionnaires were sent and 1,503 responses were received, of which 916 included complete information. The authors concluded that on average, "participants in TIAA-CREF, people who on average are better educated and more experienced at managing self-directed retirement accounts than the general U.S. population," do appear to invest according to generally accepted investment principles.

     The authors stated that their "findings suggest that, given enough education, information, and experience, people will tend to manage their self-directed investment accounts in an appropriate manner."

     The term "Generally Accepted Investment Principles" derives from the term "Generally Accepted Accounting Principles" or GAAP, which refers to accounting standards or rules used in preparing financial statements. It specifies the type of information that should be included in financial statements and how that information should be prepared. Accounting standards and GAAP can differ significantly by country and define what accounting practices are acceptable and unacceptable. Professor Bodie coined the phrase "Generally Accepted Investment Principles" and is also one of the authors of a leading textbook titled “Investments.”

Some useful links and references9

Vanguard has several investor questionnaires that will lead you through a series of questions and make a suggested allocation that investors can compare to their current portfolios or other suggestions.

American Association of Individual Investors Asset Allocation Models

Recommendations from four robo advisers and four human advisers for a hypothetical 35-year-old investor (Marketwatch, May 2, 2015)

Nacubo Asset Allocations for U.S. College and University Endowments and Affiliated Foundations (2018) (2017)

Callan Target Date Index (Glidepath Allocation)

Public pension fund asset allocations

Public pension funds may not be especially comparable to individual portfolios for multiple reasons, but they can provide an interesting reference for many investors to keep in mind. They had a median 56.69% of their holdings in equities as of September 30, 2017 according to Wilshire Trust Universe Comparison Service, as compared with 54.37% a year earlier. They also had 23.3% in bonds, down from 25% a year earlier.10 The following are some examples of large plans that publicly report their asset allocation and they are also interesting to consider in the context of the next chapter, which broadens the discussion to the major investment options and the global investing universe.

California Public Employees' Retirement System (CalPERS)

California State Teachers Retirement System (Calsters)

Virginia Retirement System

San Bernardino County Employees' Retirement Assnn

Houston Firefighters’ Relief and Retirement Fund

1. Morningstar has been providing commentary and analysis on the target date fund industry for over a decade. See Target-Date Series Research Paper: 2010 Industry Survey
and Benchmarking Target Date Funds
2. Gary Brinson, Brian Singer, and Gilbert Beebower, Determinants of Portfolio Performance II: An Update, Financial Analysts Journal, May/June 1991.
3. Gary Brinson, Randolph Hood, and Gilbert Beebower, Determinants of Portfolio Performance, Financial Analysts Journal, July/August 1986.
4. William Jahnke, The Asset Allocation Hoax, Journal of Financial Planning, January 1997
5. John Nuttall, The Importance of Asset Allocation 2000
6. Roger Ibbotson and Paul Kaplan, Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance? Financial Analyst Journal, January/February 2000. A more recent article about the debate was published in the March/April 2010 Issue of the Financial Analysts Journal “The Importance of Asset Allocation and The Equal Importance of Asset Allocation and Active Management (by James Xiong, Roger Ibbotson, Thomas Idzorek, and Peng Chen). See also Asset Allocation Is King By Thomas M. Idzorek Morningstar Advisor April/May 2010
7. Joseph Davis, Francis Kinniry Jr., and Glenn Sheay, The Asset Allocation Debate: Provocative Questions, Enduring Realities Originally published as Tokat, Y., Wicas, N, and Kinniry, F., The Asset Allocation Debate: A Review and Reconciliation. Journal of Financial Planning, 2006. This former paper is a revised and updated version.
8. Daniel Kahneman and Amos Tversky, Prospect Theory: An Analysis of Decision Making Under Risk, Econometrica, 1979
9. Those interested in a very deep and detailed analysis of retirement investing options and scenarios can download “Optimizing Retirement Income by Integrating Retirement Plans, IRAs, and Home Equity” by Wade Pfau, Joe Tomlinson, and Steve Vernon (November 2017) - 145 page report about structuring retirement portfolios.

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Last update 12/30/2019. Copyright © 2019 Gary Karz. All rights reserved.
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