Reading 25: Asset Allocation－LOS c

Strategic asset allocation combines long-term capital market expectations, investor risk and return objectives, and constraints to determine target weight to asset classes. A study by Brinson, Hood, and Beebower (1986) found that 94% of the variability of portfolio returns is explained by the portfolios strategic asset allocation. A second study by the Vanguard Group (2003) showed that more than 100% of the long-term performance of a portfolio is explained by its strategic allocation. Based on these studies and others, the importance of strategic asset allocation for portfolio performance is without question.

Williams should agree with Statement 1. Even though investment managers are experts at selecting good investments, investment managers need discipline in the search for reward versus systematic risk. A clearly defined asset allocation provides such discipline by ensuring that the investors portfolio accurately reflects the investors desires with respect to risk and return. Williams should disagree with Statement 2. It is true that over the long run, asset classes do respond somewhat homogenously to systematic (macroeconomic) risk factors, however, this supports the conclusions drawn by empirical studies that strategic asset allocation tends to explain the majority of the variability in portfolio returns. This is because the asset class selected (not necessarily the security or timing) will tend to dictate the response of the portfolio to changes in interest rates or other macro economic factors.

All three of the students statements are accurate and all three support the conclusion that strategic asset allocation is the most important factor for defining portfolio performance. A clearly defined asset allocation provides discipline and focus on an investors goals by ensuring that the investors portfolio accurately reflects the investors desires with respect to risk and return. Also, empirical studies support the conclusion that strategic asset allocation (not timing or security selection) defines the vast majority of a portfolios long term performance, and the variability of portfolio returns.