William Kinlaw - Asset Allocation

We hope we have convinced you that asset allocation does not determine 94% of performance, and that contrary to this assumption, security selection has equal, if not greater, potential to affect the distribution of returns. Does it follow, therefore, that investors should focus more effort on security selection than asset allocation? Not at all. Paul A. Samuelson put forth the argument that investment markets are microefficient and macroinefficient, which implies that investors are more likely to succeed by engaging in asset allocation than in security selection. He argued that if an individual security is mispriced, a smart investor will notice and trade to exploit the mispricing, and by doing so will correct the mispricing. Therefore, opportunities to exploit the mispricing of individual securities are fleeting. However, if an aggregation of individual securities, such as an asset class, is mispriced, a smart investor will detect the mispricing and trade to exploit the mispricing. But one smart investor, or even several, would not have the scale to revalue an entire asset class. The mispricing of an asset class will likely persist until an exogenous shock jolts many investors, smart or not, to act in concert and thereby revalue the asset class. Thus, asset class mispricing endures sufficiently long to allow investors to profit from it. 6

The notion that asset allocation is more important than security selection is based on a flawed analysis that failed to account for what an investor would do as an alternative to investing in the current portfolio. Also, many studies show asset allocation to be more important than security selection because they conflate investment choice with investment opportunity. If we correct for these two flaws, we find that security selection is at least as important, if not more important, than asset allocation. It does not follow, though, that investors should devote more resources to security selection than asset allocation, because, as argued by Paul Samuelson, it is easier to be successful at asset allocation than security selection. The bottom line is that asset allocation is very important, but not for the reasons put forth by Brinson, Hood, and Beebower.

Chapter 22shows how investors can exploit the macroinefficiency of markets to enhance returns by anticipating regime shifts.

1 Brinson, G. P. and Hood, R. 2006. “Determinants of Portfolio Performance – 20 Years Later: Authors' Responses,” Financial Analysts Journal, Vol. 62, No. 1 (January/February).

2 Brinson, G. P., Hood, L. R., and Beebower, G. L. 1986. “Determinants of Portfolio Performance,” Financial Analysts Journal, Vol. 42, No. 4 (July/August).

3 Ibbotson, R. G. and Kaplan, P. D. 2000. “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” Financial Analysts Journal, Vol. 56, No. 1 (January/February).

4 Kritzman, M. 2006. “Determinants of Portfolio Performance – 20 Years Later: A Comment,” Financial Analysts Journal, Vol. 62, No. 1 (January/February).

5 Kritzman, M. and Page, S. 2002. “Asset Allocation versus Security Selection: Evidence from Global Markets,” Journal of Asset Management, Vol. 3, No. 3 (December).

6 L'Her, J. F. and Plante, J. F. 2006. “The Relative Importance of Asset Allocation and Security Selection,” Journal of Portfolio Management, Vol. 33, No. 1 (Fall).

7 Samuelson, P. A. 1998. “Summing Up on Business Cycles: Opening Address,” in Beyond Shocks: What Causes Business Cycles, edited by J. C. Fuhrer and S. Schuh. Boston: Federal Reserve Bank of Boston.

1 1.See Brinson, Hood, and Beebower (1986).

2 2.This argument first appeared as a letter to the editor in the Financial Analysts Journal in July/August 2006. Gary Brinson and Randolph Hood responded to this critique in the same issue. See Kritzman (2006) and Brinson and Hood (2006).

3 3.We have yet to meet a manager who claims to be lucky nor one who claims to be unskillful.

4 4.See Ibbotson and Kaplan (2000).

5 5.See Kritzman and Page (2002).

6 6.See Samuelson (1998).

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