The importance of asset allocation
A major reason why investors develop policy statements is to determine an overall investment strategy. Though a policy statement does not indicate which specific securities to purchase and when they should be sold, it should provide guidelines as to the asset classes to include and the relative proportions of the investor's funds to invest in each class. How the investor divides funds into different asset classes is the process of asset allocation. Rather than present strict percentages, asset allocation is usually expressed in ranges. This allows the investment manager some freedom, based on his or her reading of capital market trends, to invest toward the upper or lower end of the ranges. A review of historical data and empirical studies provides strong support for the contention that the asset allocation decision is a critical component of the portfolio management process. In general, four decisions are made when constructing an investment strategy:
? What asset classes should be considered for investment?
? What normal or policy weights should be assigned to each eligible asset class?
? What are the allowable allocation ranges based on policy weights?
? What specific securities should be purchased for the portfolio?
The asset allocation decision comprises the first two points. How important is the asset allocation decision to an investor? In a word, very. Several studies have examined the effect of the normal policy weights on investment performance, using data from both pension funds and mutual funds, from periods of time extending from the early 1970s to the late 1990s. The studies all found similar results: About 90 percent of a fund's returns over time can be explained by its target asset allocation policy. Rather than looking at just one fund and how the target asset allocation determines its returns, some studies have looked at how much the asset allocation policy affects returns on a variety of funds with different target weights.
Good investment managers may add some value to portfolio performance, but the major source of investment return—and risk—over time is the asset allocation decision. A number of studies have shown that individual investors frequently trade stocks too often—driving up commissions—and sell stocks with gains too early (prior to further price increases), while they hold onto losers too long (as the price continues to fall). These results are especially true for men and online traders. The desire to "get rich quick" by trading in the stock market may lead to a few success stories; but, for most investors, implementing a prudent asset allocation strategy and investing over time are a more likely means of investment success. A well-constructed policy statement can go a long way toward ensuring that an appropriate asset allocation decision is implemented and maintained.
? What asset classes should be considered for investment?
? What normal or policy weights should be assigned to each eligible asset class?
? What are the allowable allocation ranges based on policy weights?
? What specific securities should be purchased for the portfolio?
The asset allocation decision comprises the first two points. How important is the asset allocation decision to an investor? In a word, very. Several studies have examined the effect of the normal policy weights on investment performance, using data from both pension funds and mutual funds, from periods of time extending from the early 1970s to the late 1990s. The studies all found similar results: About 90 percent of a fund's returns over time can be explained by its target asset allocation policy. Rather than looking at just one fund and how the target asset allocation determines its returns, some studies have looked at how much the asset allocation policy affects returns on a variety of funds with different target weights.
Good investment managers may add some value to portfolio performance, but the major source of investment return—and risk—over time is the asset allocation decision. A number of studies have shown that individual investors frequently trade stocks too often—driving up commissions—and sell stocks with gains too early (prior to further price increases), while they hold onto losers too long (as the price continues to fall). These results are especially true for men and online traders. The desire to "get rich quick" by trading in the stock market may lead to a few success stories; but, for most investors, implementing a prudent asset allocation strategy and investing over time are a more likely means of investment success. A well-constructed policy statement can go a long way toward ensuring that an appropriate asset allocation decision is implemented and maintained.
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