The capital markets have changed dramatically over the last few decades. Money management has undergone a concurrent evolution. In the early 1960s, the term asset allocation did not exist. The simple view of diversification was simply to "avoid putting all of your eggs in one basket." The argument was that if all of your money was placed in one investment, your range of possible outcomes was very wide—you might win very big, but you also had the possibility of losing very big. Alternatively, by spreading your money among a number of different investments, the likelihood was that you would not be either right or wrong on them all of the time. There was an advantage, therefore, in having a narrower range of outcomes. 

In our marketplace today, it is very difficult to imagine that the market price of any widely followed security will depart significantly from its true underlying value. Such is the nature of an efficient market. Modern portfolio theory has as its foundation the notion of efficient capital markets. As this body of knowledge developed, the focus of attention has shifted from individual securities to the portfolio as a whole. Modern portfolio theory has redefined the notion of diversification. Major emphasis must be placed on finding baskets that are distinctly different from one another. This is extremely important because each basket’s unique pattern of returns partially offsets the others, with the effect of smoothing overall portfolio volatility. (Eliminate the roller coaster ride.)

Dramatic support for the importance of asset allocation is provided by a study of 91 large pension plans from 1974 to 1983 by Gary Brinson, Randolph Hood and Gilbert Beebower. The study sought to attribute the variation in the total returns among the plans to three factors: asset allocation policy, market timing and security selection. This study dramatically supports the notion that asset allocation policy is the primary determinant of investment performance, with a minor roll played by the other factors. The study was subsequently updated in 1991 with additional data and once again arrived at the same conclusion. Asset allocation determines 91.5% of the portfolio performance, while market timing was 1.8% and security selection was 4.6%.

According to Brinson, asset allocation has become associated with successful investment management. Asset allocation is portfolio management at its most important level and not just another name for the "timing" game.  

Asset allocation is involved with the investment structure of a multi-asset portfolio. It is the investment process that brings together into one portfolio the widely different attributes and characteristics of various asset classes. It attempts to optimize the mix of asset classes relative to a set of objectives that usually contain preferences or attitudes pertaining to risk or return. Generally an investor forms an investment policy and thereby a normal portfolio mix to satisfy those specific objectives. This is accomplished by defining the normal investment characteristics (risk, return and covariance) of each asset class. Asset allocation means deviating temporarily from the normal policy mix. It is based upon judgments that one or more asset classes are in a state of dis-equilibrium with respect to the investment characteristics that were utilized in forming the policy mix.

In summary, asset allocation decisions focus upon understanding current conditions in the various asset classes and judging whether current investment characteristics are in or out of the equilibrium state that was used in determining the investor’s normal asset allocation mix. These are the fundamental investment considerations linked to the underlying cash flows associated with long term investment results.

For more information, contact:

Emerald Planning Services, Inc.
573 Millwood Road
Chappaqua, NY  10514-1317
914-241-0707 (voice)
914-864-2300 (fax)  

info@emeraldplanning.com

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