I'm not one for self-censorship, but I must admit I was forced to remove a controversial chapter from my latest book “Hey! What's My Number?” It wasn't that the contents were factually incorrect. It wasn't that they didn't like the book. Rather, they informed me, if they endorsed the book, including the offending chapter, they would publicly call into question their entire business model.
If you're immersed in the standard marketing mantra, what follows will shock you. Nonetheless, it represents empirical truths from studies by well recognized authorities. That the results of these studies have failed to break the misinterpretation of asset allocation tells you more about the power of successful marketing than the power of academic honesty.
The seminal studies upon which the foundation of asset allocation as we know it was built were conducted by three researchers: Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower (collectively known as “BHB”). The first BHB study (1986) was popularly interpreted as concluding asset allocation was responsible for 93 percent of a portfolio's return. A follow-up study (1991) refined that number to 91 percent. By the late 1990s, industry stalwarts like Fidelity and Vanguard trumpeted the “fact” that “91 percent of a portfolio's return is attributable to its mix of asset classes.”
This presents two problems: 1) BHB never said this; and, 2) subsequent research shows BHB conclusions to be flawed. BHB said asset allocation explains 91 percent of the “variation of returns,” not the returns themselves. Furthermore, in two studies (2000 and 2010), Roger Ibbotson et al demonstrated that “The BHB methodology incorrectly ascribed all 100 percent of the return variation to asset allocation, whereas, in fact, all the variation came from stock selection and general market movement.” His 2010 Financial Analysts Journal piece bluntly declared, regarding asset allocation, “The time has come for folklore to be replaced with reality.”
Moreover, the practical use of asset allocation is flawed both in the short-term and the long-term. A popular use of asset allocation is to determine asset weighting based on historical data. One report has shown how, over three decades using 10-year performance periods, optimization incorrectly predicted the “correct” asset allocation for the next 10 years. Ibbotson himself says asset allocation is not meant to work in the short term.
Of greater concern to practitioners is a long-term study showing that, over rolling 40-year periods, the best asset allocation remains a 100 percent equity exposure. This offers the highest returns and its standard deviation is among the lowest.
I'm not saying asset allocation should never be used; indeed, I believe it's more important as you get closer to the date of your ultimate goal. What I am saying is, based on empirical data, the industry, for the most part, has built an infrastructure that misapplies asset allocation. Sooner or later, the tort attorney will discover the truth behind the industry's use of asset allocation. If you're a fiduciary, you better start doing your due diligence on the subject now.
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Christopher Carosa
Chris Carosa has been writing a weekly article and monthly column for BenefitsPRO online and BenefitsPRO Magazine since 2011 and is a nationally recognized award-winning writer, researcher and speaker. He’s written seven books, including From Cradle to Retire: The Child IRA; Hey! What’s My Number? – How to Increase the Odds You Will Retire in Comfort; A Pizza The Action: Everything I Ever Learned About Business I Learned By Working in a Pizza Stand at the Erie County Fair; and the widely acclaimed 401(k) Fiduciary Solutions. Carosa is also Chief Contributing Editor of the authoritative trade journal FiduciaryNews.com and publisher of the Mendon-Honeoye Falls-Lima Sentinel, a weekly community newspaper he founded in 1989. Currently serving as President of the National Society of Newspaper Columnists and with more than 1,000 articles published in various publications, he appears regularly in the national media. A “parallel” entrepreneur, he actively runs a handful of businesses, including a small boutique investment adviser, providing hands-on experience for his writing. A trained astrophysicist, he also holds an MBA and has been designated a Certified Trust and Financial Advisor. Share your thoughts and story ideas with him through Facebook (https://www.facebook.com/christophercarosa/)and Twitter (https://twitter.com/ChrisCarosa).
