Bull or Bear Market - Asset Allocation is Important

If you are in stock market for long haul, then facing a bull market correction or a bear market is inevitable. And the wrath of a bear market on your portfolio can be devastating or unpleasant at its best. If your thoughts for managing your portfolio are confined to the range of questions mentioned below (in bullet points), then you are missing a bigger point. Individual investors usually get bogged down with questions on individual stock selection and market timing. Some of the common questions would be like:

• Which stocks should I buy?
• When is a good time to buy? to sell?
• Which fund to select? Which manager is better?

These are important too, but let me provide you with an important perspective by quoting the results from the research done by Gary Brinson, Randolph Hood and Gilbert Beebower. They presented the results of their study, "Determinants of Portfolio Performance" in Financial Analysts Journal.

The study examined the investment results of 91 very large pension funds to determine how and why their results differed. The pension funds, which ranged in size from $100 million to well over $3 billion, were studied for the 10-year period from 1974-83. Let me directly take you to the conclusion of their study because they are really stunning. They discovered that Investment Policy decision ALONE contributed to 95.6% of the variation to the total plan performance. And the actual Investment strategy (that is Market timing and Security selection) resulted in less than 5% variation. Wow! you read that right.

Another point is, the actual mean average total return on the portfolio over the period was 9.01 percent, versus 10.11 percent for the benchmark portfolio. Active management costed the average plan 1.10 percent per year.

Let me clarify that a bit. Investment Policy is the decision of allocating funds to each asset class. In this study, the asset classes were: Stocks, Bonds and Cash. For example, a portfolio might have 60% in stocks, 30% in Bonds, and 10% in cash. This decision of determining what proportion of funds goes to each asset class is the single biggest factor in determining your portfolio's performance. Who would have thought that asset allocation would be so important!

There was a big ruckus in the Wall street after this study was presented since these results would severely undermine the importance of stock market's highly praised managers and brokerage houses. However, the authors re-did their study and came back with almost identical results. The results from this debate can now be considered settled and the results are reasonably accepted. Feel free to leave a comment if you found any glitch in the research done by Brinson and party.

So what is there in it for me from this reseach. There are some important lessons to be learnt from this study and I will cover that in the next post.

-Nidhi