In the “Determinants of Portfolio Performance II: An Update,” by Brinson, Beebower and Singer, the importance of asset allocation was demonstrated in their study of large pension plans. The study sought to attribute the variation of total returns among the plans to three factors:
• Asset allocation policy
• Market timing
• Security selection
Bottom line: The conclusion was that 91.5% of the performance could be attributed to the asset allocation and only 4.6% could be attributed to security selection.
MPT Tenet #4: Portfolios Can Be Quantitatively Optimized
The fourth premise for modern portfolio theory is the optimality of portfolio returns vis-à-vis portfolio risk. In other words, portfolio diversification is not so much a function of how many issues are involved as it is of the relationships of each asset to each other asset and the proportionality of those assets in the portfolio. The extent to which knowledge of one asset return provides information regarding the behavior of another asset is measured by the correlation of returns.
Bottom line: Forty years ago it would have been nearly impossible to calculate such efficient portfolios. With the advances in computer and Internet technology, advisors now have easy access to tools that can provide quantitative methods used for measuring risk and diversification, making it possible to create efficient and theoretically optimal portfolios.
The True Measurement Of Diversification
The true measurement of diversification includes calculations of returns, standard deviations, correlations and the covariance of assets. Advisors can review a wide spectrum of alternative portfolio solutions by using multi-factor quadratic algorithms, such as those employed in AdvisoryWorld’s SCANalytics tool, in conjunction with the advisor’s own constraints and assumptions (including forward as well as backward estimates).
Many advisors have made the mistake of assuming that MPT and optimization are part of a limited, backward-looking exercise. They are not. It is best to remember that finding the appropriate investment solution for any client is as much art as it is science. It is also good to understand that making investment decisions without a sound methodology and scientific basis can result in unexpected and unnecessary liability.
Philip S. Wilson holds degrees in finance and philosophy from St. Louis University. He has been in the investment business for 48 years. He is currently President and CEO of AdvisoryWorld, which provides financial tools to investment professionals throughout the United States, Europe, South America and Asia. Learn more at www.AdvisoryWorld.com.