Is the Asset Allocation Approach Still Valid?

Revisiting the supremacy of asset allocation portfolios such as the 60/40 split with Morningstar's director of research, Paul Kaplan.

Paul Kaplan 11 May, 2022 | 4:58AM
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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 among various asset classes, such as stocks, bonds, real estate and cash. And then the allocation to each asset class is made with specific investments. The supremacy of asset allocation was largely due to two influences. First of all, Harry Markowitz's mean-variance model of portfolio construction is well suited for the division of a portfolio among asset classes. Because the Markowitz model takes advantage of the low correlation between asset classes to reduce risk. The 60\40 mix of stocks and bonds is an important special case because its level of risk and expected return are appropriate for 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 over 90% of the variation of a pension fund's portfolio return is due to asset allocation. This result was widely accepted as the justification for the asset allocation approach. A follow-up study was published in 1991. That came to the same conclusion.

This was the state of affairs until 1997 when William Jahnke published an article titled "The Asset Allocation Hoax". While the significance of the article is mainly due to its title. It caused no little controversy as it brought into question the whole edifice of asset allocation. It also led to a number of researchers including me to re-examine the Brinson studies and conduct new research. One of those new research studies was conducted by Yale professor Roger Ibbotson and me. One of our conclusions was that the Brinson studies were being misapplied.

The Brinson studies are about how the returns of a given portfolio vary over time their 90% result for this was wrongly being applied to the variation of returns across portfolios. Ibbotson and I estimated this to be about 40%. In 2010, James Xiong, Roger Ibbotson, Thomas Idzorek and Peng Chen published further research into a study titled "The Equal Importance of Asset Allocation and Active Management". So while asset allocation is very important, it does not occupy the exalted 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 discusses how despite its critics, the 60/40 portfolio has remained valid in the past and how he expects it to remain valid in the future. While it and more generally, the asset allocation approach may have been overrated in the past, they remain valid and useful.

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Paul Kaplan

Paul Kaplan  Paul Kaplan is Director of Research for Morningstar Canada.

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