1. Importance of Asset Allocation
   Source: "Determinants of Portfolio Performance", Brinson, Hood & Beebower, Financial Analysts Journal, July-August 1986. Updated 1991. Study conducted analyzing the impact of asset allocation decisions on return variability using three broad asset classes – stocks, bonds and cash.
2. Efficient Investing with Multiple Asset Classes
   Source: Stocks: S&P 500 Index. Bonds: S&P High-Grade Bond Index (1954-1973), Lehman Brothers Long-Term High Quality Government/Corporate Bond Index (1974-1975), Lehman Brothers Aggregate Bond Index (1976-2003). Past Performance does not guarantee future results.
3. Asset Classes Behave Differently
   Source: Frank Russell Company
4. Styles Rise and Fall… Randomly
   Source: Frank Russell Company
5. Why Picking Today's Hot Managers Isn’t The Solution
   Source: Frank Russell Company's Equity Accounts Universe of 123 major banks, insurance companies, and investment advisors with six years of return history ending Dec. 2005
6. Actively Managed Funds & Underperformance
   Source: Morningstar, US equity mutual funds, Russell Indexes. All total returns reflect 10 year annualized figures. Funds are categorized by their Morningstar objective.
7. Internal Expenses Do Matter!
   Source: U.S. Securities & Exchange Commission
8. Comparing Management Expenses
   Source: Frank Russell Company, 12/05

I've worked with some very bright people in my tax, corporate finance and investment advisory roles.  There are many, very bright people in every profession, especially in the investment management field.  So competition is very keen in this area, as you might imagine.

What makes matters more interesting is that since the 1970's, the money management industry has been dominated by institutional investors, not individual investors as it was previously.  Institutional investors (insurance companies, investment banks, mutual funds, pension funds, hedge funds, etc.,) all seek to hire the best and the brightest individuals from the best MBA programs, all utilize the latest technology and all spend tremendous amounts of money analyzing markets, trends, government data world events, etc., all in an attempt to do better than the key market indexes.  In fact when they do, it's called achieving "alpha."

Because such investing institutions have become so large, numerous and determined to beat the market, institutional investors in essence have become the market.  Investment management today is not a "winner's game," but rather, it has become a "loser's game."  For any one manager to outperform the other professionals, he must be skillful and so quick that he can regularly catch other professionals making errors.  He or she must be able to systematically exploit those errors faster than other professionals can.  The problem is not that investment research is done poorly.  On the contrary.  The problem is that it is done so well by so many and that no single group of investors is likely to gain a regular and repetitive useful advantage over all other investors.

Today, active institutional investment managers compete with many other experts in a loser's game where the secret to winning is to lose less than the others lose.  In addition, given the cost of active management - fees, commissions, market impact of transactions, taxes - a significant percentage of investment managers have and will over the long term under perform the overall market.

Question for you:

In 1986, in what has become a seminal study in the investment management world, Gary Brinson, Randolph Hood and Gilbert Beebower conducted an in-depth analysis of pension funds to determine the primary factors that influenced the variability in rate of of returns.  A follow-up study in 1991 updated the research and the work of other analysts supplemented it.  The Brinson Study entitled Determinants of Portfolio Performance, is referred to by financial firms of all sizes and shapes.

What this study showed was that of the three major factors that could primarily influence the overall performance of a portfolio - 1) market timing, 2) security selection and 3) asset allocation, more than 90 percent of the variability of the portfolios' performances was directly attributable to the portfolio's design (i.e., asset allocation).  Security selection accounted for less than 5 percent and market timing less than 2 percent of the variability of return.

Now why do you think that such a high percentage of the return comes from asset allocation as opposed to security selection or market timing?  Because (as mentioned above in Philosophy #1) in a world where most of the invested money is controlled by highly intelligent, highly skilled professional money managers competing against each other, and because they are so good at what they do it has become increasingly difficult for one to get an advantage over another for any extended period of time.

While there has been on-going debate by many academics and financial professionals about how the Brinson Study reached its conclusions, there is no question that asset allocation is critical to long-term portfolio performance.

Question for you:

I believe in the benefits of asset allocation.  And in studying how to allocate between asset classes and to what percentages I spend a great deal of time looking at the historical returns of various asset classes and their corresponding correlations; i.e. mathematically quantifying patterns of returns in different asset classes and relating them to one another.  Knowing the historical long-term return and risk (standard deviation) of small cap value stocks is important and understanding the correlation between small cap value and large cap growth stocks certainly is interesting.

But the one variable that investors always seem to struggle with is their own behavior!  A great example of this is found by looking at a study of mutual fund investors by Dalbar Financial Services, titled "1993 Quantitative Analysis of Investor Behavior." This study tracked money flowing in and out of stock and bond mutual funds from 1984 to 1993 and measured the time individual investors remained in the funds, as well as their returns.

During this 10-year period, the S&P 500 earned 14 percent average annual compound return.  However, the study found that the individual investors in equity mutual funds earned an average of 4.3 percent compound return during the same period.  Why the large discrepancy?  Well to quote the study: "Investment return is far more dependent on investor behavior than [on] fund performance."

So, in order for your investments to achieve anything near the historical long-term averages, you must first truly know yourself as an investor.

Question for you: