Sometimes it’s good to get back to the basics. The basics of investing are simple: a bias toward stocks, diversification, and a long time horizon. A portfolio tilted toward a diverse basket of stocks provides the engine for long-term growth.
Yet, investors have a knack for over-complicating investing by trying to do too much. The reason is due to three tools at our disposal. David Swensen described these tools as asset allocation, market timing, and security selection.
In theory, the tools allow us to “add value” and improve our returns. But only one does any real work. In fact, the other two are a net negative.
The first, asset allocation, basically deals with which assets you have in your portfolio and in which proportion you hold each of those assets. The second, market timing, deals with short-term deviations from the long-term asset allocations that you establish. And the third, securities selection, speaks to how it is you manage each of your individual asset classes. Are you going to hold the market portfolio, index your assets, match the markets results? Or are you going to manage each individual asset class actively, trying to beat the market and generate risk-adjusted excess returns?…
Because we hold relatively stable, relatively well-diversified portfolios, security selection turns out not to be an important determinant of returns for most investors and market timing turns out not to be an important determinant of returns. The last man standing is asset allocation and that tends to drive both institutional returns and individual returns.
Roger Ibbotson, who is a colleague of Bob Shiller’s and mine at the School of Management, has done a fair amount of work, studying the relative importance of these sources of returns. He’s come to the conclusion that over 90% of the variability of returns in institutional portfolios is attributable to asset allocation and that’s the number that I think most people hear cited when they are looking at Roger Ibbotson’s work. I think one of the more interesting and even simpler concepts that comes out of his study is that more than 100% of returns are defined by asset allocation. Now, how can that be true? How can asset allocation be responsible for more than 100% of investment returns? Well, it can only be true if security selection and market timing detract from institutional returns or individual returns in the aggregate.
The goal of investing is to pick an asset allocation, within your risk tolerance, that should get you close to your future goals. Then leave it alone. Let the allocation do all the work.
But that’s not what happens.
Instead, investors lean on the other two tools to add value. Those tools lead to changes in your portfolio. Changes mean trading. And more trading adds costs — fees, taxes, and opportunity — that drag down returns.
There’s a behavioral cost too that extracts a bigger cut. Market timing and security selection sound good in theory but play out poorly in practice.
Unfortunately, trying to pick the turns in the market is more of a fool’s errand than a strategy. We’re awful at it. We’re too early or too late and lose more in returns than we gain. That’s if whatever we’re trying to time actually happens.
Sadly, the market gives us numerous reasons at any moment to worry about something that turns out to be nothing. To paraphrase Peter Lynch, investors have lost more money anticipating corrections than in actual corrections.
Inflation, war, rising interest rates, and recession are recent examples of worries that we react to because it’s human nature to protect ourselves. Except, trying to avoid things that don’t happen or have less impact than we imagine, results in losing money that we would have earned had we done nothing. It’s made worse by the fact that we don’t know if we’re just early or wrong. And the waiting compounds the problem.
The results from security selection aren’t much better. There’s always an excuse to own one stock or fund over another. The most leaned upon reason is recent returns. We chase performance. We buy an asset after it has a huge run and sell it after it declines when we should do the opposite. The cycle of chasing returns becomes another drag on performance.
So market timing and security selection are a net negative on portfolio returns. Emotions are the main culprit. Asset allocation works best when it’s left alone.