Apple pie: cinnamon, sugar, flour, butter, apples, Crisco or lard, salt. Not too many ingredients. And, like any food, the higher the quality of ingredients, the better the potential flavor of the finished product.
Let’s imagine for a moment that you spend the time and money to source the absolute best quality ingredients, across the board. Everything is naturally grown, organic, and processed purely and carefully. But you use proportions that are slightly out of whack. Too much cinnamon, too much salt, and your imperfect combination of perfect ingredients is just awful.
This is BY FAR the most common mistake that I see individual investors make. (I’ll follow up this article with the second most common: going to cash when they fear the market may drop.) They spend the time researching the “best” funds available, and many folks are capable of finding excellent funds. Then they include a “dash” of a fund that should be two cups, and dump in 12 oz. of vanilla when they should have used a teaspoon. The results are a portfolio comprised of an unhelpful combination of great investments.
Determining how much of each asset class (and WHICH asset classes) is usually done by a portfolio manager (notice I didn’t say financial advisor or trust officer, although some people do wear both hats). It is a specific subset of highly technical financial knowledge. It also requires a LOT of research, often a team of researchers with expensive software and monthly subscriptions to enormous data sets. It is not static; it shifts constantly – so quickly that judgment is required to determine how often to actuate changes in reaction to those shifts, since they cannot all be acted upon.
Here’s a quick example: International equity has broadly underperformed U.S. equity over the last 20 years, and not by a small amount – just shy of 43%, using the indices in the footnote. That might lead someone to conclude that they are better off by not including international equity in their portfolio, or dramatically underweighting it. However, a closer look shows that, from 12/31/2003 through 12/31/2009, international equity outperformed U.S. equity 131% to 47% in total returns. No one could predict that and time it perfectly, of course, but a diligent portfolio manager would ideally capture at least some portion of that by increasing and decreasing exposure.
DALBAR and Morningstar frequently publish research on how investor returns are less than the funds that they invest in, somewhere between 0.5% and about 3% per year. This is due to two things: asset allocation and market timing (there is overlap between the two topics). DALBAR estimates that approximately 90% of portfolio returns come from asset allocation. You can pick the right ingredients, but still bake a throwaway pie. Now the question is, how to find the right recipe? Hint: You will find some outrageous and ridiculous asset allocation “recipes” on the internet, outright malpractice if it were a professional posting them.
I’ll conclude this topic with another article on “market timing” in the future. If we can assist you with asset allocation advice, please feel free to reach out to the Wealth Management department
, or to me personally
. We are here to help!
 For domestic equity, the MSCI USA Total Return index was used, and the MSCI ACWI EX USA Total Return represented international equity. The time period was 1/1/2000 through 6/23/2020. International total return was approximately 164%, and U.S. total return was approximately 288%.