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A Misconception - 90 percent of return comes from Asset Allocation

There is an often (really often) repeated statement that "90% of your return can be explained by your asset allocation." It's just not true, and the frequency with which it is repeated isn't making it any truer. Here's where this misconception came from, and a much better predictor of investment return.

Roots of the Rumor
In 1986, a famous paper was published in the Financial Analysts Journal entitled "Determinants of Portfolio Performance." The paper found that the mix of stocks, bonds, and cash determines how volatile your portfolio will be. In fact, it stated that this asset allocation mix explained a whopping 93.6 percent of a portfolios' volatility.

While I haven't gone back to check the work from this study, the results sound reasonable. But the key word in this study was that asset classes explained "volatility." No where did the study indicate that asset class mix explained performance. And despite the belief investors seem to have that these words are interchangeable, they are not. Perceiving them as being the same is a big mistake.

The big difference between volatility and performance.
Volatility is a measure of the riskiness of an asset. Stocks are more volatile than short-term government bonds, for example. Performance is the total return produced by the asset. As a general rule, assets with greater volatility have a greater long-term expected return.

To see an example of where volatility and performance diverge, let's compare two portfolios, each including only one asset. One portfolio contains the Rydex S&P 500 index fund (RYSYX), while the other contains the Vanguard S&P 500 index fund (VFINX). Both contain virtually an identical portfolio of 500 U.S. based stocks weighted by market capitalization. The only key difference between these two funds is the annual expense ratio. The Rydex fund charges 2.28% annually while the Vanguard fund only charges 0.16% annually.

According to the original study in 1986, these two portfolios should have roughly the same volatility since they have exactly the same asset class. And, in fact, they do. According to Morningstar, the Rydex fund has an annual standard deviation (a measure of volatility) of 19.96 percent, while the Vanguard fund is a tiny bit lower at 19.89 percent.

But since the Rydex fund charges an extra 2.12 percent annually, one can predict with a great amount of accuracy that the Vanguard Fund will outperform the Rydex fund by 2.12 percent annually. The only difference in return explained outside of the expense ratios is from the index tracking error.

So what does explain the investment performance variation?
There is only one predictor of portfolio performance in comparing funds of the same asset classes. Many think it's the Morningstar fund rating, but even Morningstar suggests you not pick funds solely on its five star rating system. That one predictor is costs. Higher costs lead to lower returns.

My advice
Since the object of investing is to increase returns while decreasing risk, the answer becomes clear. Own the broadest index funds such as total U.S. stock, total international stock, and total bond funds with the lowest costs.

Regardless of how often you hear someone say asset class explains 90 percent of performance, the truth remains that it's volatility, not performance. There's a big difference between the two, and confusing them is an even bigger mistake for your financial future.

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