The Decision That Matters Most: Why Asset Allocation Drives Everything Else

Last week, I wrote about “Asset Location,” which is the process of optimizing your holdings amongst different account types to create the most tax-efficient portfolio. In that piece, I emphasized that this approach should always be secondary to Asset Allocation, which is the process of optimizing the overall structure of your portfolio between asset classes like stocks, bonds, cash, and other assets.

When you ask most people what makes an investor successful, you will hear about picking the right stock, buying at the right moment, or finding a manager with the magic touch. All of this makes for good conversation and provides for some excitement, but over the long run, the real driver of risk and return in most investors’ portfolios is determined by a far simpler metric.

The decision that shapes a long-term investor's experience more than any other is far less glamorous. It is Asset Allocation: the basic question of how your money is divided among stocks, bonds, cash, and other asset classes. Get that mix right, and the details tend to take care of themselves. Get it wrong, and you will end up with a sub-optimal investment experience: doomed to be forever stuck in a loop of chasing returns when you should be emphasizing safety and sitting on the sidelines during times of market strength.

What the Research Actually Found

The idea took hold in the 1980s and 1990s, when researchers Gary Brinson, Randolph Hood, and Gilbert Beebower studied the returns of large pension funds and asked a pointed question: What explains why a portfolio's returns rose and fell the way they did over time? Their answer surprised the industry. The overwhelming share of that variability, the “ups and downs” of the ride, was explained not by which securities the managers chose or when they bought and sold, but by the portfolio's underlying allocation policy.

In the decades since this landmark study, many have misinterpreted the conclusions. To be clear, the research did not claim that allocation determines ninety percent of your dollar returns. What it showed is that the mix of asset classes, more than security selection or market timing, drives the pattern of a portfolio's ups and downs over time. Later work by Roger Ibbotson and others refined the picture, but the central lesson survived intact: The allocation decision is the foundation, and the rest is trim. In other words, over the long haul, it is more important for you to own the right amount of stocks than it is for you to own the right stock.

Why the Mix Carries so Much Weight

The reason is not mysterious once you look at how asset classes actually behave.

Stocks and bonds have fundamentally different personalities. Over long stretches, stocks have delivered higher returns, but they demand a stomach for steep and sometimes frightening declines. Bonds return less but hold steadier, cushioning a portfolio when equities fall. Cash returns least of all and preserves capital, offering full protection against loss of principal. In recent years, there has been a lot of discussion and research on adding other “alternative” asset classes to the mix, but generally speaking, most investors remain focused on splitting their portfolio between stocks, bonds, and cash.

These are not interchangeable ingredients; each brings a distinct blend of risk and reward to the table, and these different aspects tend to make these assets complementary to each other. When you combine them, something useful happens. Because these asset classes do not always move in the same direction at the same time, a thoughtful mix can smooth the overall ride by dampening the worst of the drawdowns without giving up all of the growth. That is the quiet power of diversification—sometimes called the only “free lunch” in investing—and it is why the stock-to-bond split functions as the master dial of any portfolio. Nudge that dial toward stocks and you turn up both the expected return and the volatility. Nudge it toward bonds and you turn both down. Almost every other decision is a rounding error by comparison.

Matching the Mix to the Person

None of this tells you what your allocation should be, because the right mix is not a matter of arithmetic. It is a matter of fit.

Two questions do most of the work. First, how long is your money going to be invested? A 35-year-old funding a retirement three decades away can weather volatility that would be reckless for someone drawing income next year. Time is the great absorber of risk.

Second, and just as important, how much turbulence can you actually tolerate? Not in theory, but when you can’t sleep at night after watching your hard-earned savings evaporating at an alarming pace and when it feels like the entire system may come crashing down? The finest allocation on paper is worthless if it frightens you into selling at the bottom (there is a lot of very interesting research on the disconnect between what people say/think their risk tolerance is and how they actually behave, something I plan on writing about in a future column).

On the flipside, it’s theoretically easy to accept lower returns in exchange for some safety, but when it feels like everyone around you is getting rich in a bull market, will you stick to your allocation, or will you turn up the risk just before the market peaks? An allocation you can hold through a difficult market will beat one that is “optimal,” but which features too much risk (or too little return) for you to stomach and which you end up abandoning in the heat of the moment.

While many Advisors pay a lot of lip service to tailoring Asset Allocation decisions to the individual client, the reality is that they are largely basing these decisions on two factors: Age and self-reported risk tolerance. As discussed above, age is important as it tends to be a solid proxy for measuring the length of time before a client needs to begin withdrawing from a portfolio. However, every family is unique and has different financial circumstances; things like life expectancy, health, assets, income, expenses, expectations of significant future inflows or outflows (like an inheritance or paying for college), and dozens of other factors should also be considered.

That is why the mix should evolve as life does. The portfolio that serves a young saver rarely suits a retiree, and a well-built plan shifts gradually as the years pass and priorities change. Additionally, two investors can look nearly identical on paper, but have wildly different asset allocation plans. The price of getting this decision wrong is amongst the steepest an investor can pay.

Evolving Over Time

Setting the allocation is only part of the task. The other parts are maintaining it—something that requires a discipline the market is forever trying to talk you out of—and adjusting it as your circumstances and portfolio evolve over time.

Left alone, a portfolio drifts. A long stock rally quietly swells the equity share until you are carrying far more risk than you intended, right when you feel most comfortable. Rebalancing—periodically trimming what has grown and adding to what has lagged—pulls the mix back to target. It also enforces the buy-low, sell-high instinct that nearly everyone endorses and almost no one executes, precisely because it asks you to act against the mood of the moment. If nothing else, having some of your portfolio in bonds or cash provides “dry powder” to put to work during equity market drawdowns.

First Things First

I wrote recently in this space about asset location—the art of holding each investment in the account where it is taxed most kindly. That process is important and can have a meaningful impact on your financial future, but it is the second decision, not the first. Location refines the returns your allocation makes possible; it cannot rescue an investment mix that never suited you to begin with.

There is a lot that goes into deciding on an appropriate asset allocation plan (a process I plan on discussing in more depth in future columns now that we have laid the groundwork). While most people seem to think the role of a Financial Advisor is to “pick the right stocks,” an experienced and competent Advisor will spend far more time on this conversation than on discussing the details of individual investments. Let this process, more than any hot tip or market forecast, be the thing that carries you. In investing, the foundation is not the exciting part, but it is the part that holds everything else up.

Robinson Crothers is Managing Partner at Great South Bay Advisors in Holbrook. This column is for general educational purposes and is not individualized investment, tax, or legal advice. Securities and investment advisory services offered through Osaic Wealth, Inc., Member FINRA/SIPC. Great South Bay Advisors and Osaic Wealth, Inc. are not affiliated.