Paul Kaplan: I’m Paul Kaplan, director of research at Morningstar Canada. By the late 1980s, the asset allocation paradigm was widely accepted as the best way to invest. In this approach, a portfolio was first divided between different asset classes, such as stocks, bonds, real estate and cash. And then the allocation to each asset class is done with specific investments. The supremacy of asset allocation is largely explained by two influences. First, Harry Markowitz’s mean-variance model of portfolio construction is well suited to dividing a portfolio between asset classes. Because the Markowitz model takes advantage of the low correlation between asset classes to reduce risk. The 60/40 combination of stocks and bonds is an important special case because its level of risk and expected return suit many investors.
The other major influence was a study published in 1986 by Gary Brinson and some of his colleagues at Brinson Partners. In this study, Brinson and his co-authors found that more than 90% of the variation in a pension fund’s portfolio return is due to asset allocation. This result has been widely accepted as justification for the asset allocation approach. A follow-up study was published in 1991. It came to the same conclusion.
This was the situation until 1997, when William Jahnke published an article entitled “The Asset Allocation Hoax”. While the importance of the article is mainly due to its title. It caused significant controversy because it challenged the whole asset allocation edifice. It also led a number of researchers, including me, to re-examine Brinson’s studies and conduct new research. One of these new research studies was conducted by Yale Professor Roger Ibbotson and myself. One of our conclusions was that Brinson’s studies were poorly applied.
The Brinson studies look at how returns on a given portfolio vary over time, with their 90% result being erroneously applied to the variation in returns between portfolios. Ibbotson and I estimated that at around 40%. In 2010, James Xiong, Roger Ibbotson, Thomas Idzorek and Peng Chen published additional research in a study titled “The Equal Importance of Asset Allocation and Active Management”. So, although asset allocation is very important, it does not occupy the privileged position suggested by the Brinson studies.
So what about today, Morningstar’s John Rekenthaler recently published an article titled “Why the 60/40 portfolio continues to outlast its critics.” In this article, Rekenthaler explains how, despite his criticisms, the 60/40 portfolio has remained valid in the past and how he expects it to remain so in the future. Although it and more generally, the asset allocation approach may have been overrated in the past, it remains valid and useful.