The Importance of Asset Allocation vs. Security Selection: A Primer
We are proud to announce a new Primer on Asset Allocation vs. Security Selection. You can download it here.
Investment results depend mostly on the market you choose, not the selection of securities within that market.
For mutual funds and pensions, market returns and asset allocation explain 90% of quarterly fund returns on average. In other words, institutions tend not to deviate materially from their strategic asset allocation.
Asset allocation explains over 100% of long-term performance for institutions, so traditional sources of active management are not able to overcome costs and fees.
Asset Allocation vs. Security Selection (or, The Forest and the Trees)
By far the greatest source of personal consternation as a professional in markets is investors’ obsession with finding the best stocks, or the best stock pickers. The fact that investors pursue this objective at all undermines all meaningful arguments about efficient markets. After all, why on earth would the well informed, rational actors that constitute efficient markets spend all their time on the component of the investment process that is likely to make the least amount of difference to their long-term wealth?
You see, the ability to pick the best securities (for example, individual stocks and bonds) in a chosen market is much less important than one’s choice of market itself. Does it matter how well one can choose stocks from a market if that market is dramatically underperforming?
Consider the example of emerging market equities, which underperformed U.S. equities by more than 55% over the 5 years through November 2015. And one need not go so far afield as emerging markets to find other examples with similarly large dispersion, as developed international markets also lagged U.S. stocks by a substantial margin.
The Vanguard FTSE Developed Markets (ex-US) ETF (VEA) generated just 20% total return, or 3.7% per year, lagging US stocks by 8.4% annualized (Data source: CSI). Now, consider that the Vanguard US Total Stock Market ETF produced over 14% per year over the past 5 years.
Now, what is the likelihood that an investor – even a great investor – who chose stocks from non-US markets over the past five years was able to outperform even a poorly skilled manager selecting from U.S. stocks?
The answers will surprise you. Download the Primer here.