How Does Asset Allocation Affect Risk/Return?

by: Vanguard

Summary

Over time, broadly diversified funds tend to align with overall financial market performance. Global investing is the most diversified option available, yet it’s an underutilized approach.

Investors often tilt their portfolios toward a “home” bias—focusing primarily on assets within their own country. However, market-cap- weighted global indexes may be a more valuable starting point.

While it has the potential to outperform the market, on average, active management tends to reduce a fund’s returns while increasing its volatility compared to a passive index-based portfolio.

In 1986, in "Determinants of Portfolio Performance,"¹ Gary Brinson, L. Randolph Hood, and Gilbert Beebower concluded that asset allocation is the primary driver of return variability for a broadly diversified portfolio over time. Since then, some investment professionals have disagreed with the findings.

This Vanguard research paper aims to bring clarity to the topic by examining two key questions: How does asset allocation affect your risk/return expectations? And how much home bias is reasonable?

Use this paper to:

  • Review the two competing studies on asset allocation's relationship to a portfolio's risk/return levels: "Determinants of Portfolio Performance" and "The Asset Allocation Hoax."²
  • Analyze whether asset allocation is the primary driver of return variability in broadly diversified portfolios.
  • Understand the role home bias tilts can play in determining asset allocation in a portfolio.

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Sources

  1. Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, 1986. Determinants of Portfolio Performance. Financial Analysts Journal 42(4):39-48; reprinted in Financial Analysts Journal 51(1):133-8, 1995. (50th Anniversary Issue.)
  2. William W. Jahnke, 1997. The Asset Allocation Hoax. Journal of Financial Planning 10(1):109-13.