The Quality Portfolio Demands Quality Time
Investors are not spending enough and need to start spending more! They need to start spending more time defining their goals and objectives, understanding how investment markets work and gathering knowledge about how to construct an investment portfolio, rather than simply buying and selling on whim which is akin to speculating. I might add that the time spent defining goals needs to be quality time.
How important is asset allocation in constructing a portfolio and in determining the performance of that portfolio over time? This question and other variations have been asked many times, but the precise answer depends on how the question is asked. Brinson, Hood and Beebower determined that on average more than 90 per cent of the variability in the performance of a portfolio over time is explained by its underlying asset allocation.
That is, the composition of the portfolio in shares, property, bonds and cash coupled with how each of these asset classes behaves provides enormous explanatory power. So if the question is about the level of volatility in returns associated with a portfolio over a given period then clearly asset allocation is vitally important, and other factors such as market timing and security selection pale into insignificance.
This is consistent with the view that it is extremely difficult to consistently and reliably add value over extended periods of time through market timing and stock picking. In effect, the wins and the losses cancel each other out, leaving just the direction and magnitude of investment market movements.
However, if an investor was interested in understanding the difference in performance arising between distinct portfolios then that would be a separate question altogether. Ibbotson and Kaplan examined this issue in their paper for the Financial Analysts Journal, which was published in January 2000. They found that about 40 per cent of the variation in returns amongst the portfolios in their sample of around 150 managed funds could be explained by differences in their asset allocation.
The remaining 60 per cent was explained by other factors such as market timing, security selection and differences in fees and charges. This conclusion does not undermine the Brinson Hood and Beebower findings, but rather is addressing a different question. Ibbotson and Kaplan calculated that the high level of active management (stock picking, market timing and tactical strategies) employed by the funds in their survey resulted in a correspondingly diminished role for asset allocation as a determinant of portfolio performance. They estimated that if the fund managers had been half as active then the value of asset allocation in explaining differences in performance would have risen to 81 per cent.
What this means is that investors must make a choice. The choice is to either construct a portfolio using asset classes and a passive style, which implies that their investment experience will be heavily influenced by the erratic but inexorable, rise in investment markets over time, or adopt a more active approach. Those who embrace an active approach will reduce the importance of asset allocation, which means that their investment experience will have less to do with the underlying markets and rely heavily on their stock picking and market timing skills. They should also make provision for the increased costs associated with active management. Hedge funds are an extreme example of this approach and their results are not compelling
When the potential stakes are famine or feast it becomes easier to see why active investors think nothing of interrupting their holiday to trade shares, but not so easy to see why they wouldn’t choose the simpler and cheaper passive option, assuming they know it exists.
Ibbotson and Kaplan also found that on average about 100 per cent of the returns that were achieved by the managed funds they surveyed could be explained by the asset class returns. So on average market timing and stock picking added no value above the return of the market. As discussed above, and mathematically demonstrated by William Sharpe in 1991, this is unremarkable because we should expect that on average the winners and losers will cancel each other out leaving just the overall market return to be shared amongst investors.
An investor spending too much money on trading and active management would do well to save some of their money and instead spend their time learning about the importance of asset allocation and the source of long term return.