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John and Mary enjoyed investing and were very talented. In fact, after commissions, bid-ask spreads and other costs, they both were able to match the total returns for large-cap, small-cap, international and bond indexes. (Indexes incur no trading or other costs.)

They were very competitive and wanted to see who had been the better investor. Their total returns during the three-year periods of 1997-1999, 2000-2002 and 2003-2005 were summarized. John's (Mary's) cumulative total returns for the years ending in 1999 were +94.7 percent (+47.0 percent); in 2002 were -34.5 percent (-10.5 percent); and in 2005 were +26.6 percent (+63.0 percent). John's (Mary's) cumulative total returns for the entire nine years were +61 percent (+114 percent). John's portfolio was much more volatile than Mary's, yet Mary's did better over the nine-year period.

John liked taking risks. His portfolio held United States large-cap stocks (85 percent) and small-cap stocks (15 percent). He hit home runs during the first three-year period (+94.7 percent) and struck out in the second three-year period (-34.5 percent). After this loss, John's appetite for risks waned. During the final three-year period, he put 50 percent in bonds and reduced his allocation to United States large-cap stocks (45 percent) and small-cap stocks (5 percent).

Mary had a much lower appetite for risks. Her portfolio held bonds (40 percent) and 20 percent each in United States large-cap stocks, United States small-cap stocks and foreign stocks. She knew that bonds and foreign stocks would diversify her risks. During the final three-year period, she expected that bonds would not do very well with the Federal Reserve steadily increasing the discount rate. She reduced her bond allocation by 20 percent and increased her allocation to small-cap and international stocks by 10 percent each.

Investors are supposed to be compensated for taking on risks. Why were Mary's cumulative returns 53 percent higher than John's (114 percent versus 61 percent)? And should Mary have gloated when she was declared the better investor?

A landmark paper published in 1986 by Gary Brinson and colleagues concluded that, over time, a portfolio's asset allocation determines over 90 percent of its performance. Security selection and market timing play minor roles. A research paper in 2000 by Yale professor Roger Ibbotson and Paul Kaplan, then chief economist at Ibbotson Associates, reaffirmed Brinson's conclusions. In July, I attended the Financial Analysts Seminar at Northwestern University and had the pleasure of hearing Gary Brinson discuss this seminal paper on its 20th anniversary.

Asset Allocation. Properly managing financial assets begins with a sound, long-term investment policy tailored to your goals and objectives. It is the foundation upon which the portfolio is constructed and managed over time and through bear or bull markets. Primary asset classes are cash, bonds, stocks and real estate. Stocks styles include small/large, value/growth, cyclical/defensive, sector/industry and domestic/foreign. There are bond styles, too. Your investment policy should specify your target asset allocation and the amount the actual asset allocation can vary from the target. For example, Public Employees' Retirement System of Mississippi (PERS) has the following strategic asset allocation: domestic equities (50 percent), non-U.S. equities (15 percent), domestic bonds (30 percent) and real estate (5 percent). Actual asset allocation should vary from the target asset allocation when managers identify certain asset classes and styles that are expected to outperform or under perform.

Security Selection. It is the process of finding and investing in specific stocks (and bonds) that will outperform other stocks (and bonds). Charles Ellis wrote, "since the active manager will want to make as many 'right' decisions as possible, he will assemble a group of bright, well-educated, highly motivated, hardworking professionals whose collective purpose will be to identify under priced securities to buy and overpriced securities to sell. … Unhappily, the basic assumption that most institutional investors can outperform the market is not true." There are thousands of very bright and capable security analysts trying to find winners for their clients. Because of this, there are not many "bargains" to buy. Stocks (and bonds) are thoroughly shopped and mispriced securities are difficult to find. That's why good "stock pickers" find it difficult to add much value to their clients' accounts.

Market timing. This is the process of getting in the market when it is expected to do well and getting out when it is expected to do poorly, which generates many trades. Market timers have found that predicting the future is not easy; that generating trading costs (commissions, bid-ask spreads and others) frequently eliminates the benefits of trading; that incurring higher fees for active management of your portfolio is not worth the costs; and that realizing taxable gains from trading is a serious drag on after-tax returns.

Conclusion: Security selection and market timing only account for about 10 percent of your performance. Since asset allocation determines 90 percent of your portfolio's performance, shouldn't 90 percent of your time be focused on that?



Roger E. Muns, CFA and CPA, of Wealth Management, LLC, in Jackson, is president of Chartered Financial Analysts® (CFA) Society of Mississippi.

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