Where Portfolio Returns Really Come From

Here is a shocking fact: Asset allocation, the idea of spreading one’s money into different buckets or asset classes, accounts for 90% of a portfolio’s return over time. This leaves a paltry 10% of performance tied to security selection and market timing.

Think of how radical this fact actually is. When you turn on CNBC or tune into Jim Cramer, you don’t hear cogent discussion on asset allocation. Rather, what you do hear is an expert waxing eloquent about his current prognostications on the market’s direction or which stock to buy or sell – market timing and stock selection advice. As the finance media spins like a whirling dervish over these matters, many investors wring their hands wondering if they should buy or sell, get in or get out. All the while real returns are being determined by the investor’s ability to identify and rebalance to asset allocations.

At MarketRiders, we sometimes describe asset allocation like the peloton in the Tour De France. The peloton is the large group of riders that move together in a pack. In the front, a strong rider “pulls”, a term for breaking the wind for the rest of the group. The lead rider must work up to 25% harder to help the peloton while the other riders enjoy drafting behind this lead rider. Once the lead rider becomes exhausted, he pulls back into the group, letting the next rider move forward to take a pull. Cyclists call this pacelining, and they know that by working together, they will, over the length of the race, achieve a significantly higher speed than riding alone. Even Lance Armstrong in his heyday could not come close to holding an individual pace that could match the speed produced through the shared work of the peloton.

Asset classes behave similarly. For a season, one asset class will be out front, outperforming. But surely enough, in time, that asset class tires and drops back, in a sense, to regroup. Another asset class moves forward to pull your portfolio closer to your retirement goal. By keeping your target exposure to all your asset classes through disciplined rebalancing, you benefit like a cyclist in the peloton, always enjoying the work of a strong asset class that is leading your portfolio forward. To see how asset classes have performed over the past ten years, take a look at our education page.

Asset allocation worked just like pacelining over the past ten-year period of investing – a period billed “the Lost Decade”. It was one of the worst in the past 100 years, with US equities losing a shocking 0.2% annually according to Wilshire Associates. As Rick Ferri pointed out in an interesting Forbes article, an investor who embraced a simple asset allocation strategy by diversifying across four classes (US stocks, foreign stocks, bonds, and REITS) and rebalanced to that allocation, realized a return of 4.2% compounded annually. Like a peloton, while US stocks got exhausted, the other classes pulled the group ahead. Although this may not be the most exciting return, but for a lost decade, it isn’t too shabby. Asset allocation works.