Some investment portfolios do better over time than others. That obvious fact that may seem to have an equally obvious cause ~~ differences in market timing (buying and selling securities at advantageous times) or in the selection of individual securities. But, if you look at the historical record, the reason some portfolios have better returns than others looks very different. Analysts who examined the performance of 82 large pension funds over a 10-year period* found this surprising reason for superior returns: The funds' asset allocation policies accounted for 91.5% of their results. Neither securities selection nor market timing was the key factor.
Asset allocation simply applies the basic risk-limiting investment principle of diversification to the proportion (distribution) of a portfolio's investments among different investment classes ~~ for example, stocks, bonds, and cash equivalents (money market securities, including CD's). Also, asset allocation can determine the proportion of investment styles within each asset type.
The Risk/Return Tradeoff
Any investment portfolio has a range of possible returns along with a corresponding amount of risk (the variability of returns). Usually, there is a tradeoff of return vs. risk. The types of investments that offer low returns are the types that also have low risk. The investments that offer the possibility of higher returns also involve higher risk. Asset allocation can favorably alter this risk vs. return tradeoff. With an efficient asset allocation, potentially higher returns become possible with little or no increase in risk. Or, if risk control is more important, efficient asset allocation can preserve a portfolio's returns, yet reduce its risk.
Correlations in Performance
Asset allocation can alter a portfolio's risk because ~~ under certain economic conditions ~~ some types of investments have an historical tendency to gain or lose value together. Other types of investments have a tendency to move in opposite directions. Statisticians call these tendencies "correlations." The types of investments that have tended to move together, such as bonds and high-dividend paying stocks, are positively correlated. The types of investments that have tended to move oppositely, for example, bonds and growth stocks, are negatively correlated. So, a portfolio manager can lower overall portfolio risk (variability of returns) ~~ without lowering the possible return ~~ by using a mix of positively and negatively correlated investments.
Time Lowers Risk
A manager can use asset allocation to structure a portfolio that has the ability to perform well in different economic climates. The risk reduction and potentially higher returns that asset allocation provides are long-term benefits. So, an asset allocation plan requires time to succeed. Over one or two years, for example, one style of equity investing, such as large company stocks, may strongly affect overall portfolio performance. Yet, over 10 years or more of changing economic climates, equity styles have tended to have much narrower performance differences.
Any investor should consider his or her own risk tolerance ~~ over any investment time frame ~~ when making an asset allocation decision