Asset Allocation: Investing's Only Free Lunch

Along with fees, asset allocation has the greatest influence on the returns of your investment portfolio

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While everyone dreams about getting rich by buying the next hot tech stock or jumping into a booming foreign market, successful stock picking and market timing are extremely difficult for even the savviest professional investor. For the do-it-yourself investor who can't spend every waking hour crunching numbers and studying the market, it is all but impossible. Thankfully, the long-run returns on your investment portfolio depend more on other factors that are in your control. After the impact of fees, which my colleague Ben Johnson wrote about here, asset allocation is the greatest decision influencing the returns of your investment portfolio, and it is a relatively simple concept to put into practice with the use of exchange-traded funds (ETFs).

The main idea behind asset allocation is that over any timeframe, some asset classes will go down while others will go up, but no one knows in advance which one will do what. The trick is not to try and guess where to put your money, but to spread out your portfolio to gain exposure to any bull markets and avoid the full brunt of a bear market. This asset diversification minimises the risk of large losses while not giving up much in expected long-term return. Psychologically, sticking to a well-defined asset allocation will help you to avoid selling out after a large loss, which is probably the worst move an investor can make; just ask anyone who exited the equity markets at the end of 2008 and completely missed last year's big rally.

Asset allocation can even explain why some funds do well and others don't. Numerous academic studies show that asset allocation explains a significant percentage of the variation of returns across funds, including Morningstar Ibbotson's own 2000 study "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?" While we don't want to get into the nitty-gritty behind these studies, if we accept the premise that active management adds little value that investors can't get themselves through prudent asset allocation, then ETFs become a great investment vehicle for do-it-yourself investors.

The special strength of asset allocation comes from rebalancing--redistributing assets from overheated asset classes to those that are out of favour, which can increase returns while minimising risks in your portfolio. We can demonstrate the incredible power of diversification and rebalancing by creating a simple example of a hypothetical portfolio using four major asset classes: three regional stock indices and global bonds. To represent a broad array of stocks we use the DJ Stoxx 50 Total Return Index for large-cap European companies, the S&P 500 Total Return Index for large-cap US companies, and the MSCI Emerging Markets Gross Return Index for large-cap emerging markets equities. For bonds, we use the Barclays Capital Intermediate Global Total Return Index. Investors can access all these indices by choosing from multiple ETFs.

We used a 20-year timeframe for our hypothetical portfolio, starting from the beginning of 1990 up until the end of 2009, and denominated our portfolio returns in pound sterling. This period is a good sample because it included both bull and bear markets, allowing the power of diversification to really shine through. The best performing index over this timeframe was the S&P 500, with a 14.2% annualised return even after the lacklustre last decade because the 1990s were such a phenomenal time for the US market. Unsurprisingly for such a long time period, the bond index was the worst performer among our examples with a 6.9% annualised return.

Now let's create our two hypothetical portfolios with an initial investment in 1990 spread equally amongst these four indices. A proper balanced portfolio wouldn't blindly divide equally between these four asset classes, especially as it produces a very aggressive, stock-heavy portfolio with massive emerging markets exposure, but for illustrative purposes this hypothetical portfolio will work beautifully. After investing two portfolios equally in each of the four indices, we will have the first portfolio be strictly buy-and-hold, while the second one will annually rebalance to return the portfolio to its initial mix.

After 20 years have passed by, the buy-and-hold portfolio would have increased an investor's wealth by 10.6% annually, a better result than three out of the four indices. While the outstanding performance of the S&P 500 through the 1990s gave this portfolio a large lead halfway through this race, eventually rebalancing proved to be a wise move as the second portfolio ended up with an annualised return of 11.4%. While this doesn't sound like a large difference, keep in mind that the extra 80 basis points of performance compounded over 20 years increased our hypothetical portfolio by more than 100% of the initial investment! When you're compounding returns, every extra little bit counts.

While a straight investment in the S&P 500 would have provided a greater return than either of our diversified portfolios, an investor shouldn't ignore risk in evaluating investment opportunities. Using standard deviation of returns as a proxy for risk, both of our hypothetical portfolios proved to be steadier rides than any of the three all-stock indices, and our rebalanced portfolio steadier than our pure buy-and-hold portfolio. On a risk-adjusted basis, a strict asset allocation strategy with regular rebalancing is hard to beat.

Of course, not many people invest a large chunk of cash at one time without ever adding to it. To reflect additional savings as people add to their portfolio, we created two more hypothetical portfolios which included monthly contributions of 1% of the initial investment. Once again, we created a buy-and-hold portfolio as well as a portfolio which annually reallocated equally amongst our four indices. Just as in our last example, investors who rebalanced regularly would have been pleased with that decision, as both returns and risk were superior to the buy-and-hold strategy.

Obviously both of our examples were simplified; we ignored the effects of transaction costs, taxes and other important considerations. Counting the costs of buying new ETF stakes would not have weighed on the rebalancing strategy sufficiently to make the pure buy-and-hold portfolio superior, but would have substantial effects on the cost efficiency of monthly new investments. Still, we believe the evidence is clear that over a long-term horizon, asset allocation including a regular rebalancing programme is a powerful tool for investors.

So if you've accepted the arguments in favour of asset allocation, how do you go about optimising your portfolio? Morningstar has several tools available to help in making asset allocation decisions, ranging from the Instant X-Ray tool on our website to Morningstar Encorr for institutional users. In addition, consider using ETFs in forming your portfolio as there are multiple options available for all of the major asset classes including fixed income, equities, cash, commodities, real estate, and foreign currencies.

There is no 'right' answer when it comes to asset allocation, as it can vary greatly on an investor's own circumstances. Age, risk tolerance, other sources of income and other factors need to be accounted for. The most important point to keep in mind is that investors need to set realistic financial goals, create a plan to meet them and then stick to that plan through the ups and downs of the market.

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Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure

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