Wednesday, August 27, 2008

The Limits of Asset Allocation

The idea behind asset allocation is that by carefully choosing how much of each asset class (like cash, bonds, and stocks) to own, you can get higher returns without taking on more risk. Any sub-optimal portfolio can replaced with an optimized portfolio with higher expected return or lower risk.

This mantra has been preached by many commentators to the point where thoughtful investors devote so much attention to their asset allocations that they lose sight of other important considerations. But, optimizing your asset allocation gives less benefit than you might realize.

An Example

Suppose that Jen has a retirement portfolio made up of 40% bonds and 60% stocks. We’ll assume that the stock and bond money is invested in low-cost index exchange-traded funds (ETFs) to minimize fees. Using the figures from the paper Portfolio Optimization by John Norstad (2002-09-11), Jen can expect a compound return of 5.23% per year above inflation.

What happens if we allow Jen to include cash in her portfolio? It turns out that the optimal portfolio with the same risk as Jen’s portfolio is 8% cash, 30% bonds, and 62% stocks. What difference does this make? The expected return above inflation goes from 5.23% to 5.24%. Whoop-de-do. Investing $10,000 over 25 years, Jen could make an extra $70.

Another Example

Maybe Jen was just lucky and had a nearly optimal portfolio to begin with. Suppose that Jim’s portfolio is 30% cash and 70% stocks. Surely we can improve on this. The optimal portfolio with the same risk as Jim’s portfolio is no cash, 35% bonds, and 65% stocks. The expected return above inflation goes from Jim’s 5.35% to an optimized 5.46%. This is a much bigger difference, but 0.11% is still not huge. Investing $10,000 over 25 years, Jim could make an extra $1000.

It’s possible that larger differences could be found by mixing in other asset classes like real estate, commodities, and international stocks, but optimal asset allocation is not going to have the same benefit as a 1% lower management expense ratio (MER).

I’m not saying that asset allocation is unimportant. It matters, but it doesn’t make as big a difference as many people might think. Fortunately it isn’t necessary to choose between proper asset allocation and low investing fees. There are so many low-cost ETFs of different types available that you can have your cake and eat it too.

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