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If you could only make one decision in your investment strategy, what would it be? Would you concentrate on picking the best securities? The best ETFs or mutual funds? Would you focus exclusively on trying to time your asset allocation/rebalancing choices? Or maybe you'd spend a lot of time deciding if Asian stocks would beat European equities in the foreseeable future. Or how about managing the risk, however defined, like a hawk? In any case, the question is simply this: Which variable in the money game is likely to have the most influence on the end result of performance?

Depending on the investor, answers are likely to be all over the map. And perhaps that's reasonable, since we left out a critical piece of information for answering intelligently: time horizon.

What's the single-most important investment decision driving return? We can't respond shrewdly unless we know the length of time we'll be investing. If we're managing money with an end point of, say, next year, or even a few years down the road, the critical variable may be different (is likely to be different) than if you're investing for results 20 years on.

This isn't terribly surprising, although the time horizon distinction is often minimized, if not ignored, in discussions of everything from security selection to asset allocation. Part of the problem is that in theory we're all long-term investors but we're destined to make the journey on a tick-by-tick, daily basis. Even the self-proclaimed day trader has a horizon beyond the next 24 hours. A 35-year-old who trades furiously during the day still wants a comfortable retirement 40 years hence. Perhaps the only investors with truly short, or shorter time horizons, are older folks, although even that's debatable, depending on your estimate for longevity.

In any case, back to our question: What's the single-most important variable that influences portfolio return? If we're investing with an eye on maximizing return 20 years from now, the answer is one of basic asset allocation: stocks vs. bonds vs. cash. Assuming some reasonable level of diversification in stocks and bonds, choosing individual securities will have a minimal impact, if any. And it probably won't matter much if you overweight U.S. stocks vs. foreign stocks, or vice versa.

Consider, for instance, a few statistics. For the period 1970-2008, the annualized total return for domestic stocks (S&P 500) was 9.5% vs. 9.7% for foreign stocks (MSCI EAFE (NYSEARCA:EFA)), according to the Ibbotson SBBI Classic Yearbook. Not a huge difference for that 38-year stretch. The future's always uncertain, of course, but generally over long periods it's likely that regional differences in equity beta will be minimal relative to the global stock market beta.

In the shorter term, however, it's a different story. Looking at returns by decade for the S&P 500 and MSCI EAFE shows a wider array of results. For the 10 years through 2008, EAFE gained an annualized 1.2% vs. a 1.4% annualized loss for the S&P 500. In the 1990s, the relative performance tables were turned, with a much bigger divergence. U.S. stocks earned an annualized 18.2% for the decade through the end of 1999, more than double the annualized rise for MSCI EAFE, which gained 7.3% during the 1990s on an annual basis. (For a slightly more technical analysis of this trend, see William Bernstein's 1997 treatment of this topic.)

Meantime, we can also show that bond returns over time tend to be quite modest relative to stocks. Again, no big surprise. What's more, assuming reasonable diversification, your choices on short vs. long term bonds, or domestic vs. foreign, probably isn't going to matter so much. Yes, there's the foreign currency factor to consider, particularly when it comes to bonds. But over time, the capacity for forex to add or subtract from equity and bond returns tends to be a wash (i.e., the expected return for currencies proper is zero). In the short run, however, lots of forex volatility, and therefore lots of risk, which may or may not be helpful, depending on the investor and the strategy.

What's the lesson in all of this? Your overall stock/bond/cash allocation is where the action will be over the long haul. But there's a glitch. Although we're all long-term investors, at least in theory, the long-run future arrives one day at a time. In fact, almost no one builds a portfolio today and lets it roll on, unattended, over the next 20 years. That's true even for foundations, which theoretically have an infinite time horizon. Actually, a passive strategy that's broadly diversified would probably fare quite well over time, assuming we chose a reasonable mix of stocks and bonds, such as 60% equities/40% fixed income.

But the set-it-and-forget mentality is hard to do. We're all constantly buffeted by the daily barrage of headlines and other mental matters that compel us to act. For those with discipline and an above-average level of financial analytical abilities, short-term trading can be productive. But adding value over the long haul is rare by way of short term trading, especially after deducting for taxes, commissions and other frictions. In other words, most of us will end up with middling results. The problem is that everyone thinks they're above average when it comes to money.

So what's the big-picture message here? First, don't lose sight of the fact that in the long run, your overall stock/bond/cash mix will perform the heavy lifting for generating performance results, for good or ill. (We might add in REITs and commodities, if we're inclined to embrace a bit more nuance for matters of portfolio design). But getting from here to there is complicated, which is to say that you'll be faced with numerous tactical decisions. There'll be opportunities to add as well as subtract value from your end result, and so we must proceed cautiously on a day-to-day basis.

The good news is that there are some things to do that are likely to add some value, even if you're no financial wizard, starting with rebalancing and owning multiple asset classes. Beyond these two factors, however, things get messy, at least for most investors, and that includes the issue of time horizon. In effect, we're all short term traders with a long-term horizon. This is the original sin that comes prepackaged with investing. We can't escape it, but neither can we fully solve for it.

Balancing the short and long term is a key element in the art of investing—the intertemporal risk for asset allocation, as it's known in the literature. Robert Merton formally identified this risk in the early 1970s in a series of seminal papers and financial economists have been grappling with the related challenges ever since. So, too, have investors, for that matter, even if they don't recognize the risk on those terms.

Yes, we've picked up a few clues in the game of managing money for the long run while juggling short-term risk. We know, for instance, that expected returns vary, and so reversion to the mean is likely, even though the reasons are hotly debated (i.e., market efficiency vs. irrational investing decisions). But there's still no hard and fast solution beyond some general rules of thumb, such as own a broad mix of stocks and bonds, perhaps with some cash and so-called alternative betas. There's also compelling evidence that active management won't help much over the long sweep of time.

The debate, however, is a Wild West show for the short term. Or, as J.P. Morgan, once said, prices fluctuate, proving, if nothing else, that there's at least one concept in finance that's universally accepted.

Source: Understanding the Critical Factors in Portfolio Return