Your Asset Allocation

Your asset allocation is the most important decision you will make as an investor; in general, see Asset Allocation on our site. Ideally it will be reflected in your investment policy; see An investment policy: don't leave home without one on our site.

The key to any asset allocation policy is the percentage of your portfolio invested in equities. For simplicity, rules of thumb assume a portfolio invested only in stocks and bonds, and an allocation that varies with your age. A typical rule of thumb is 100 - your age (for example, for a 40 year-old person, 100-40 yields a 60% weighting in equities). Inversely this same formula gives a percentage investment in bonds equal to your age; see The Investor's Manifesto by William J. Bernstein: a book review ; Bikker 2009 pension fund asset allocations and age , p.6 or as a PDF doc.1662 (quoting Malkiel, A Random Walk Down Wall Street, 2007); and Infanger Stanford U 2009 or as a PDF doc.1663 , p.5.

But others advocate a more aggressive approach, arguing that  life expectancy is getting longer; see Asset Allocation and Age CNNMoney . Thus some propose 110 - your age (for the same 40 year old, this gives 110-40, or 70% in stocks), or an even more aggressive 120 - your age (for the same person 40 year old, the formula of 120-40 puts you 80% in equities). See DoughRoller 2007 Asset allocation or as a PDF doc.1664 ; AmateurAssetAllocator or as a PDF doc.1665  ; and Dogu 2009 Forbes Bogleheads asset allocation or as a PDF doc.1666. 

Can we quantify the likely contribution of your investment policy, which sets out your asset allocation, towards the long-term performance of your investments? Here as well, there is a range of opinions.

The most often quoted number to explain the importance of asset allocation to the long-term performance of a portfolio invested in a diversified portfolio of shares is 90%. This number was originally quoted in a study in 1986 by Brinson and others; see Wikipedia- asset allocation , note 1.That leaves only 10% for market timing and individual stock picking. 90% is a huge number.

In 2000 Ibbotson and Kaplan doc.98 criticized the use made of the Brinson study, and argue that the 90% number only explains the variation in performance of a portfolio, not its comparative long-term performance (Ibbotson doc.1675 renewed his criticism in 2010; see also DisciplinedInvesting doc.1676). They argue that, depending on the precise wording of the question, the importance of asset allocation is any of 40%, 90% or 100%. In comparison, Paul Merriman, in an article doc.935 in 2007 by Dimensional Fund Advisors published on the site www.fundadvice.com , cites a study of investment returns by 44 pension funds showing that 96% of long term return differences could be explained by the types of assets in their portfolios, leaving a meager 4% for market timing or stock picking. 

Whatever number you use (we ourselves tend to use the 90% number for discussion purposes), your investment policy and asset allocation will have enormous importance for the long-term performance of your portfolio.

There is a sub-question to all of this for Canadian investors. Since the Canadian stock market is so small (less than 3% of world stock markets), following a strictly index approach means a very small percentage of Canadian stocks in the portfolio of a Canadian investor. This is not what we find in practice. Because of favorable taxation of dividends from Canadian sources, a desire to reduce exchange risk, and greater familiarity and ease of purchasing Canadian securities, Canadian advisers typically recommend a overweighting in Canadian equities.

The question then becomes overweighting by how much? We discuss the issue on our website under Geographical diversification .There is no right or wrong answer on the number, but in our model portfolio the equity portion is invested 25% in Canada; see The financial markets in 2009: how did your portfolio do?. This leaves a very important percentage to be invested outside of Canada, a wise decision considering how historical returns have varied significantly by country; see Equity investments, Time and Irrational Optimism on our site.