By Alan Rambaldini
Along with fees, asset allocation has the greatest influence on the returns of your investment portfolio.
While everyone dreams about getting rich by buying the next hot-tech stock or jumping into a booming foreign market, successful stock-picking and market-timing are extremely difficult for even the savviest professional investor. For the do-it-yourself investor who can't spend every waking hour crunching numbers and studying the market, it is all but impossible. For those investors, it should be a comfort to know the long-run returns on your investment portfolio depend more on other factors in your control. After the impact of fees, asset allocation is the greatest factor influencing your investment portfolio's returns, and it is a relatively simple concept to put into practice with the use of exchange-traded funds.
The main idea behind asset allocation is that over any timeframe some asset classes will go down while others will go up, but no one knows in advance which will do what. The trick is not to try and guess where to put your money, but to spread out your portfolio to gain exposure to any bull markets and avoid the full brunt of a bear market. This asset diversification minimizes the risk of large losses while not giving up much in expected long-term return. Psychologically, sticking to a well-defined asset allocation will help you to avoid selling out after a large loss, which is probably the worst move an investor can make. Just ask anyone who exited the equity markets at the end of 2008 and completely missed 2009's big rally.
Asset allocation can even explain why some funds do well and others don't. Numerous academic studies show that asset allocation explains a significant percentage of the variation of returns across funds, including Morningstar Ibbotson's own 2000 study "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?" While we don't want to get into the nitty-gritty behind these studies, if we accept the premise that active management adds little value that investors can't get themselves through prudent asset allocation, then ETFs become a great investment vehicle for do-it-yourself investors.
The special strength of asset allocation comes from rebalancing (redistributing assets from overheated asset classes to those that are out of favor, which can increase returns while minimizing risks in your portfolio). We can demonstrate the incredible power of diversification and rebalancing by creating a simple example of a hypothetical portfolio using four major asset classes: three regional stock indexes and global bonds. To represent a broad array of stocks we use the S&P 500 Total Return Index for large-cap U.S. companies, the STOXX 50 Total Return Index for large-cap European companies, and the MSCI Emerging Markets Gross Return Index for large-cap emerging-markets equities. For bonds, we use the Barclays Capital Intermediate Global Total Return Index. Investors can access all these indexes by choosing from multiple ETFs.
We used a 22-year timeframe for our hypothetical portfolio, starting from the beginning of 1988 and ended February 2010. This period is a good sample because it included both bull and bear markets, allowing the power of diversification to really shine through. The best-performing index over this timeframe was the MSCI Emerging Markets Index, with a 13.5% annualized return, which was aided by the U.S. dollar's relative weakness over the last decade. Unsurprisingly for such a long time period, the bond index was, with a 6.7% annualized return, the worst performer among our examples.
Now let's create our two hypothetical portfolios with an initial investment in 1988 spread equally among these four indexes. A properly balanced portfolio wouldn't blindly divide equally among these four asset classes, especially as it produces an aggressive, stock-heavy portfolio with large emerging-markets exposure, but for illustrative purposes, this hypothetical portfolio will work beautifully. After investing two portfolios equally in each of the four indexes, we will have the first portfolio be strictly buy-and-hold, while the second one will annually rebalance to return the portfolio to its initial mix.
After 22 years have passed, the buy-and-hold portfolio would have increased an investor's wealth by 10.4% annually, a better result than three out of the four indexes. While there was little to gain by rebalancing through the 1990s, eventually it proved to be a wise move as the second portfolio ended up with an annualized return of 11.1%. While this doesn't sound like a large difference, keep in mind that the extra 70 basis points of performance compounded over 22 years increased our hypothetical portfolio by more than 100% of the initial investment! When you're compounding returns, every extra little bit counts.
While a straight investment in the MSCI Emerging Market Index would have provided a greater return than either of our diversified portfolios, an investor shouldn't ignore risk in evaluating investment opportunities. Using standard deviation of returns as a proxy for risk, our buy-and-hold portfolio was much less volatile than the MSCI Emerging Markets Index, and our rebalanced portfolio was a steadier ride than any of the three all-stock indexes or our pure buy-and-hold portfolio. On a risk-adjusted basis, a strict asset-allocation strategy with regular rebalancing is hard to beat.
Of course, not many people invest a large chunk of cash at one time without ever adding to it. To reflect additional savings as people add to their portfolio, we created two more hypothetical portfolios, which included monthly contributions of 1% of the initial investment. Once again, we created a buy-and-hold portfolio, as well as a portfolio that annually reallocated equally among our four indexes. Just as in our last example, investors who rebalanced regularly would have been pleased with that decision, as both returns and risk were superior to the buy-and-hold strategy.
Obviously, both of our examples were simplified; we ignored the effects of transaction costs, taxes, and other important considerations. Counting the costs of buying new ETF stakes would not have weighed on the rebalancing strategy sufficiently to make the pure buy-and-hold portfolio superior but would have substantial effects on the cost efficiency of monthly new investments. Still, we believe the evidence is clear that over a long-term horizon, asset allocation, including a regular rebalancing program, is a powerful tactic for investors.
So if you've accepted the arguments in favor of asset allocation, how do you go about optimizing your portfolio? Morningstar has several tools available to help in making asset-allocation decisions, ranging from Morningstar.com's Instant X-Ray tool to Morningstar EnCorr for institutional users. In addition, consider using ETFs in forming your portfolio as there are multiple options available for all of the major asset classes, including fixed income, equities, cash, commodities, real estate, and foreign currencies.
There is no "right" answer when it comes to asset allocation, as it can vary greatly depending on an investor's own circumstances. Age, risk tolerance, other sources of income, and other factors need to be accounted for. The most important point to keep in mind is that investors need to set realistic financial goals, create a plan to meet them, and then stick to that plan through the ups and downs of the market.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.