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Post #11 – The Importance of Equity Allocation, Part I

The single most important concept in investment planning is asset allocation. At its most basic level, asset allocation is deciding how to apportion your portfolio between equity assets and fixed income assets. This is a fundamental decision every investor must make. Asset allocation is important because, on a long term basis, it affects both your average annual return and the risk you must take to obtain the average return.

There have been several studies over the last 25 years that have concluded that your equity allocation (percentage of stocks in your portfolio) is the single largest determinant of your investment return over time. For example, a study published in 1986 by Gary Brinson, L. Randolph Hood and Gilbert Beebower, concluded that asset allocation, rather than stock picking or market timing, is by far the most important factor impacting your portfolio returns. In fact, the Brinson/Hood/Beebower study concluded that, over time, 94% of your portfolio return is determined by the percentage allocated to equities.

Another study, completed in 1999, by Roger Ibbotson and Paul Kaplan concluded that only about 40% of your portfolio return is due to equity allocation. The remaining 60% of a portfolio’s performance results from other factors. These factors are changes in asset classes, stock sector selection and other market timing moves. After reading this study my reaction was, well of course timing your asset class changes and/or sector weightings will help your portfolio returns. The only problem with this is how to know when to “time” these changes.

The Ibbotson/Kaplan study is suggesting that there may be an advantage to using professional fund managers to make these market timing changes for you. But other studies show that, on average, 80% of active fund managers do not outperform their market benchmark indexes in any given year. The 20% of active fund managers who do outperform their benchmark index are different every year. This tells me that, over time, some active fund managers will outperform the market some years and other years they will not. Thus, in my opinion there is no point in paying the higher fees charged by active fund managers to outperform the market since they do so inconsistently and most likely their years of outperformance will be offset by their years of underperformance. Part of the reason an active fund manager has difficulty outperforming their benchmark index is because they have higher fund management fees. The impact of a fund’s management fees on returns will be the subject of a future post, but, for now, understand that your long term market returns will mostly be determined by your equity allocation, and this is something you can control.

The table below shows the average annual returns (from 1990 to 2009) for each equity allocation from 100% fixed income to 100% equity. As the table shows, the higher your percentage equity allocation, the higher your long term returns.

Average Annual Returns of Different Equity Allocation for 20 Years from 1990 to 2009

-Equity portion is S&P 500 Index Including Dividends

– Fixed Income is 30% ST Treasuries & 70% Intermediate Term Treasuries

– Portfolios “Re-balanced” Annually

The results in the above table include from 1990 to 1999 which was a strong bull market for stocks but it also includes the secular bear market from 2000 to 2009 which we are still in. Future average returns may not be as high as shown in the table, but the relative returns when increasing your equity allocation as shown in the table should still apply. Therefore, the table confirms that the higher your equity allocation, the higher your returns should be over time. Future blog posts will discuss some “tactical” investing considerations, but first, you must make a “strategic” decision regarding your percentage of equity allocation.

However you cannot just implement a portfolio of 100% stocks to get the highest return, even if you are a young investor. There are several reasons for this. The number one reason against a 100% equity portfolio is because of market volatility. Even the person with the biggest investment risk appetite experienced much angst over the market volatility we have experienced in recent years. As I will continue to emphasize in future blogs, to be a successful investor, you must maintain discipline with your investments. A big part of maintaining financial discipline hinges on your being able to handle your portfolio’s volatility. There were many investors in early 2008, which had portfolios with 80% or more equity allocation. Many could not handle the market meltdown that occurred in late 2008 to early 2009 and sold their equities near the market bottom, only to miss the market rally that followed later in 2009-2010. If you cannot maintain your investing discipline, market volatility can really hurt your portfolio returns.

So what is the best equity allocation for you? That depends on several factors including your desired portfolio returns, your investment timeline, and most important your risk tolerance. You cannot identify your desired average portfolio return without considering the risk associated with that return. In my opinion, investing is largely about managing risk. My next post will discuss how to find a balance between the risk level you are comfortable with and the desire for a higher rate of return on your portfolio.

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