Asset Allocation Can’t Save Us, But It’s Still Crucial For Portfolio Results

Is asset allocation unimportant after all in the grand scheme of managing wealth? Yes, according to a new study the Center for Retirement Research at Boston College. “The focus on asset allocation is misplaced,” advises “How Important Is Asset Allocation To Financial Security In Retirement?” On first glance this finding sounds like a knock-out blow to all the studies through the years that tell us that asset allocation is a critical variable for portfolio management. Should we now abandon the idea? In a word, no.

The paper appears to offer radical advice by way of a shocking disclosure. In fact, the study’s not telling us anything that wasn’t already obvious. The authors demonstrate that a number of tools and techniques beyond asset allocation are of greater influence on the outcome of financial planning decisions over long periods of time—particularly for investors with relatively small portfolios. The message is that investing results alone may not suffice for most folks in the all-important task of saving for retirement. How you manage assets is important, but that can can pale next to how much you earn over the course of a lifetime, and how much you save along the way.
This isn’t terribly surprising, and it certainly doesn’t change what we know about asset allocation and its relationship with risk and return over the long haul. Nonetheless, you still can’t get blood out of a stone and asset allocation won’t help all that much if your portfolio is small relative to what’s needed to engineer a secure retirement. As the authors explain,

Strikingly, the typical 401(k)/IRA balance of households approaching retirement is less than $100,000, which suggests that the net benefits of portfolio reallocation have to be modest for the typical household. Although it is possible that higher income households have more to gain.

A simple Excel exercise aimed at determining the required saving rates for individuals with different starting ages, ending ages, and asset returns showed that the difference between earning a real return of 2 percent instead of 6 percent could be offset by working five years longer. This finding suggests a minor role for asset allocation in creating a secure retirement.

The paper concludes: “Given the relative unimportance of asset allocations, financial advisers will be of greater help to their clients if they focus on a broad array of tools – including working longer, controlling spending, and taking out a reverse mortgage.”
Agreed. But this is hardly a smoking gun that invalidates asset allocation. True, designing and managing the portfolio mix through time can’t overcome the headwinds of, say, not saving enough assets to properly fund retirement. Asset allocation won’t make you any taller or smarter either. But within the realm of the portfolio, asset allocation and rebalancing remain the primary factors driving the risk/return profile. That hasn’t changed, nor will it. The fundamental laws of finance are written in stone.
Meantime, there is a risk of trying to be too clever with asset allocation. It’s hard to beat a broadly diversified, unmanaged multi-asset class portfolio in the long run without taking big risks–risks that may or may not pay off. For instance, the Global Market Index—a passive, unmanaged mix of the major asset classes weighted by market values—outperformed nearly 90% of 1,200-plus multi-asset class mutual funds for the 10 years through the end of 2011.
But if we’re talking about the broader array of influences on an individual’s wealth, it’s necessary to look beyond money management. To note the obvious, or what should be obvious: your career is likely to have a bigger impact on your retirement than your decision on how much to hold in stocks vs. bonds vs. REITs vs.commodities. Even the greatest portfolio strategy in the world won’t do much to help you reach financial goals if your investment assets are minimal, or if you lose your high-paying job and have to settle for flipping hamburgers. At the opposite extreme, it’s no great revelation to discover that a CEO with a multi-million-dollar salary can ignore asset allocation—and investing in general—and still do quite well for himself.
None of this alters the reality that asset allocation and rebalancing are the key variables that govern results through time for most portfolios. That may not be terribly relevant for your financial health in general. But if we’re talking about managing portfolios, asset allocation is still on the short list of key factors.