Despite what some analysts say, asset allocation is about allocation of risk

By DAVID MOON, Moon Capital Management
August 19, 2001

When stock prices decline, people say some pretty goofy things.

As long as the S&P 500 and all of the closet indexers enjoyed the fruits of irrational exuberance, growth stock investing was the holy grail of Main Street investors, if not those on Wall Street. Now that some of the unprecedented imbalance between the growth and value areas is corrected, folks are trotting out some old horribly misunderstood and intellectually dubious arguments to sell their advice.

Perhaps you have seen or heard someone refer to the importance of the asset allocation decision in determining portfolio performance. Advisors cite studies claiming that the relative percentage of your portfolio in different asset classes (stocks, bonds, international stocks, real estate, etc.) is the primary determinant of your portfolio returns. Let's see if we can state it another way: 'it is better to own more of the stuff that increases in price instead of the stuff that goes down.' No kidding.

The only question remaining is, 'which asset class is about to have the highest returns? I want to buy that one, so I will have the highest returns.' Many of the asset allocation people don't address this issue. Instead, they argue for broad diversification across every asset class, just to make sure you own the class that does best. Of course, this strategy also almost guarantees an investor will own the asset class that does most poorly. Other than the Psychic Hotline, there is no evidence that anyone can reliably predict which asset class will be in favor next week, year or market cycle.

But the biggest problem with the asset allocation policy people is a misinterpretation of their own data. Even the folks at some highly respected mutual funds companies cite a well-known study on asset allocation, incorrectly claiming the asset allocation decision is responsible for 90 percent of a portfolio's performance. But that is not what the study said. The study actually concludes that asset allocation is responsible for 90 percent of the performance difference in two separate portfolios ' not the return of a single portfolio.

Without trying to sound like a statistician, that conclusion is significantly different than the notion that asset allocation determines 90 percent of a portfolio's returns. Perhaps it is an easy distinction to miss, particularly if you have already predetermined the point you want to make and are just looking for ammunition to defend the position. Lies, damn lies and statistics. Trouble is, however, someone, particularly an investment professional, needs to take the time to understand the statistics he is using to justify his claim.

What role does asset allocation play in a portfolio? It is the means by which an investor can match her money and her risk tolerance. If an investor is risk averse and can't stand to lose any principal investments, she better not have ten percent of her portfolio in an emerging markets fund. A young, aggressive investor with no concern for daily volatility could easily withstand a large percent of his portfolio in stocks. While these decisions may seem relatively simple for individuals, they are more complicated for institutions, investing pooled accounts for a large, heterogeneous group of beneficiaries. But asset allocation is still about allocating risk, not predicting returns.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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