Market Returns Re-examined: What Really Matters

In 1986, Gary Brinson and others wrote a paper, often cited as one of the most important in financial research. It indicated that asset allocation, or the process of dividing investments among different categories of stock and bonds, accounted for 90% of market returns.

This straight forward message caught on and is the standard today for most financial advisors. It was a boon for software makers of asset allocation models. It covered 10 years of pension returns. Now, that hallmark paper is being re-examined.

Past performance is no indication of future results (certainly not just 10 years like Brinson’s study)

Roger G. Ibbotson, founder of Ibbotson Associates, reports in the March-April issue of the Financial Analysts Journal that asset allocation was given too much weighting in explaining market returns in the 1986 paper. His re-examination shows that the analysis in the original paper did not justify its conclusion, that asset allocation is responsible for 90% of market returns.

Instead, he suggests that return is due primarily to market movement (about 75%) and the remainder is split between asset allocation and active management. Remember, the Brinson study covered only ten years. This may have been too short a time.

For example, in 2008 when the entire market was down, asset allocation mattered little. This was also true in 2009 when stocks were up. Ibbotson’s revised interpretation of Brinson and colleagues work supports the old adage, “A rising tide lifts all boats and vice versa.” In other words, when the market is up, stock portfolios are too, provided they aren’t all in cash. The reverse is also true.

Cinching what really matters

This concept is explored in more detail in another article, also published in the March April issue of the Financial Analysts Journal. By using detailed time-series and cross-sectional regression analyses, the authors show that market motion is far more important than either asset allocation or active portfolio management.

In fact, it is responsible for 75% of returns (or lack thereof). This is something not even Ben Bernanke can control. Think back to our recent crises. The remainder of excess return over this often seemingly random up and down market fluctuation is divided between asset allocation and active management.

Perhaps the most important message here is to always be in the market to the degree you feel comfortable (this is where asset allocation comes in). It is the only way not to lose its general trend upwards, in part due to inflation.

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