William J. Bernstein - The Intelligent Asset Allocator

The Intelligent Asset Allocator

How to Build Your Portfolio to Maximize Returns and Minimize Risk

William J. Bernstein

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On July 31, 1993, I came across an article in The Wall Street Journal (Your Money Matters series) which examined the performance of various asset allocations for the period 197392. The article was based on research done at the T. Rowe Price mutual fund group. The technique used was quite simple: imaginary portfolios were constructed from various combinations of U.S. large and small stocks, foreign stocks, and U.S. bonds, and returns and risks were calculated. The article pointed out that over the 20-year period studied various fixed mixes of the above assets outperformed the single component parts (as well as most professional money managers), with significantly lower risk. I was intrigued. T. Rowe Price kindly sent me the data underlying their calculations, which I analyzed. The results were astonishingalmost any reasonably balanced fixed combination of the four assets outperformed most professional money managers over the same period.

For example, a simpletons portfolio consisting of one quarter each U.S. large stocks, U.S. small stocks, foreign stocks, and U.S. high-quality bonds had a higher return, with much lower risk, than large U.S. stocks alone (represented by the S&P 500 index). The S&P 500, in turn, performed better than 75% of professional money managers over the same period.

I was fascinated by the T. Rowe Price data; here was a simple tool for ascertaining historical asset allocation performancecollect data on the prior performance of various asset classes, and backtest returns and risks. To my disappointment, I could find no readily available software which accomplished this; I would have to write my own spreadsheet files. I began to buy, beg, steal or borrow data on a wide variety of assets over several different historical epochs and build portfolio models going back as far as 1926.

The calculations performed by T. Rowe Price and myself contained an important implicit assumption: that the portfolios were rebalanced periodically. Rebalancing becomes necessary after a while because some assets in a portfolio will do better than others, and this will alter the original portfolio composition. In order to rebalance the portfolio back to its starting composition, some of the better performing assets must be soldand the proceeds used to purchase more of the poorly performing assets.

Most experienced investors learn that the key to long-term success lies in a coherent strategy for allocation among broad categories of assets, principally foreign and domestic stocks and bonds. They also understand that market timing and stock or mutual fund picking are nearly impossible long term. They are at best a distraction. Put another way, it is far more important to come up with the right proportion of foreign stocks, U.S. stocks, foreign bonds, and U.S. bonds than it is to pick the best stocks or mutual funds or to call the tops or bottoms of the markets. (As we shall see later, nobody consistently calls the market, and almost nobody picks stocks or mutual funds with any persistent skill).

If you find this difficult to believe, consider the following: 1987 was not a great year for the U.S. stock market. U.S. large company stocks (represented by the S&P 500) gained only 5.23% that turbulent year, and small company stocks actually lost 9.3%. On the other hand, foreign stocks gained 24.93%. The clumsiest foreign fund manager would have beaten the most skillful small-stock picker that year. In 1992, the opposite would have occurred when U.S. small stocks gained 23.35% and foreign stocks lost 11.85%. Finally, the 19951998 period provided unprecedented returns for the biggest U.S. growth stocks but battered almost everything else.

Still not convinced? In the late 1980s, Gary Brinson, a noted money manager and financial analyst, and his colleagues published two sophisticated statistical studies of 82 large pension funds. They concluded that asset allocation accounted for over 90% of the return variability among the funds, with a less-than-10% contribution from market timing and actual stock and bond selection.