It's about the mix, stupid!

Market Insight

Your returns are governed by the broad asset allocation rather than individual stock-picking.

In 1986, Gary Brinson, Randolph Hood and Gilbert Beebower published "Determinants of Portfolio Performance", a study that caused a storm. They looked at quarterly returns of 91 corporate pension funds over 1974-83. Their calculations suggested 93.6 per cent of returns on investments were determined by mix of asset classes, rather than by holdings of specific assets.

This meant the broad outlines of where money was parked mattered far more than previously acknowledged. If you decided 50 per cent of your assets needed to be in real estate, 30 per cent in equity and 20 per cent in debt instruments, that was the key. It didn't matter much if the real estate was Gurgaon or Bhopal; the equity was Larsen & Toubro or Infosys; if the debt was corporate or treasury.

The huge, obvious implications turbo-charged the financial planning industry, kickstarted an entirely new class of asset allocation mutual funds (fund of funds or FoF) and led to the creation of pop quizzes that helped people assess sensitivity to risk and reward.

Financial planning is clearly beneficial for wealth creation and FoFs are useful instruments. Even if the average quiz is much too blunt an instrument, it's useful to try and understand risk-reward profiles. So these were all good outcomes.

But the study itself may have been flawed - certainly some of the methodology was. In 1997, William Jahnke published a rebuttal, "The Asset Allocation Hoax" where he tore the 1986 study apart. According to Jahnke, asset allocation accounted for only about 14.5 per cent of returns on the same data!

The truth is (probably) in-between but the original study was apparently closer to the mark. In 1998, Ibbotson and Kaplan concluded that it depended on interpretations of the variability of returns. But they also said the original study was correct in its claim that asset allocation was of overwhelming importance.

However, Morningstar, the influential financial asset monitor, also revisited the debate and came down on Jahnke's side though it suggested that asset allocation did have a significantly higher effect on returns than Jahnke's low values.

In 2000, William O'Reilly and James Chandler tried a brute force approach, described in the Journal of Financial Planning. They constructed 10,000 artificial FoFs! Each had asset allocations of 50 per cent US large-cap equity (chosen from a class of 153 funds) + 30 per cent US fixed-income (38 funds) + 10 per cent US short-term fixed income (16 funds) +10 per cent non-US equity (25 funds) created by randomly mixing the appropriate funds. Then they changed the asset allocation to 60:30:0:10 and repeated. Then they switched time-frames. After massive number-crunching, they said close to 90 per cent of returns were in fact, predictable from the asset mix.

There is an intuitive way for the practical investor to cross the maths barriers. Suppose you held 50 per cent of your portfolio in stocks (with say, an average 20-year return of 20 per cent) and 50 per cent in fixed income (average 20-year return of 10 per cent). Your expected return would be close to 15 per cent.

If you want 18 per cent a year, what do you do? Do you maintain asset allocation and find a multi-bagger to replace an under-performing stock? Or, do you move more assets out of debt and into equity? The second method is more likely to succeed.

There are caveats. One would have preferred a wider asset mix in the studies cited. Also, nobody has ever conducted an exercise as extensive as this, using Indian data. Indian markets, especially bond markets, are much less perfect than in the US. The results may differ a lot from above.

But the sheer scale of the O'Reilly-Chandler study makes it very likely that asset allocation is important in any market. In that case, most investors have a flawed approach. As individuals, we spend much more time on specific picks rather than trying to get our broad asset allocations right.

The point is, if the return from the asset allocation mix versus the return from specific holding is skewed 85:15 or even 70:30, it is ridiculous to spend 95 per cent of your time worrying about specific assets. Get the mix right!

Even in India, there is long-term data available on the returns on various asset classes. If you have that, and a clear target for the returns you want, it should be possible to get there with a fairly high degree of accuracy.