If one were to poll investors and investment professionals to determine their ideal investment scenario, the vast majority would no doubt agree: It's a double-digit total return in all economic environments, each and every year. Naturally, they would also agree that the worst-case scenario is an overall decrease in asset value. But despite this knowledge, very few achieve the ideal—and many encounter the worst-case scenario. The reasons for this are diverse: misallocation of assets, pseudo-diversification, hidden correlation, weighting imbalance, false returns, and underlying devaluation.

The solution, however, could be simpler than you would expect. In this article, we will show how to achieve true diversification through asset class selection, rather than stock picking and market timing.

The Importance of Asset Class Allocation

Most investors, including investment professionals and industry leaders, do not beat the index of the asset class in which they invest, according to two studies by Gary P. Brinson and Gilbert L. Beebower entitled "Determinants of Portfolio Performance" (1986) (with L. Randolph Hood) and "Determinants of Portfolio Performance II: An Update" (1991) (with Brian D. Singer). This conclusion is also backed up by a third study by Ibbotson and Kaplan entitled "Does Asset Allocation Policy Explain 40%, 90% or 100% of Performance?" (2000).

This underperformance phenomenon begs the question, if a U.S. equities growth fund does not consistently equal or beat the Russell 3000 Growth Index, what value has the investment management added to justify their fees? Perhaps simply buying the index would be more beneficial.

Furthermore, the studies show a high correlation between the returns investors achieve and the underlying asset class performance. For example, a U.S. bond fund or portfolio will generally perform much like the Lehman Aggregate Bond Index, increasing and decreasing in tandem. This shows that, as returns can be expected to mimic their asset class, asset class selection is far more important than both market timing and individual asset selection. Brinson and Beebower concluded that market timing and individual asset selection accounted for only 6% of the variation in returns, with strategy or asset class making up the balance.

Figure 1: A breakdown of factors that account for variation in portfolio returns

Broad Diversification Across Multiple Asset Classes

Many investors do not truly understand effective diversification, often believing they are fully diversified after spreading their investment across large-, mid- or small-cap stocks; energy, financial, health care or technology stocks; or even investing in emerging markets. In reality, however, they have merely invested in multiple sectors of the equities asset class and are prone to rise and fall with that market.

If we were to look at the Morningstar style indexes or their sector indexes, we would see that despite slightly varying returns, they generally track together. However, when one compares the indexes as a group or individually to the commodities indexes, we do not tend to see this simultaneous directional movement. Therefore, only when positions are held across multiple uncorrelated asset classes is a portfolio genuinely diversified and better able to handle market volatility, as the high-performing asset classes can balance out the underperforming classes.

key takeaways

  • A high correlation exists between the returns investors achieve on their holdings and the underlying asset class performance of those holdings.
  • True portfolio diversification is achieved through selecting and holding a variety of asset classes, rather than individual stock-picking and market-timing.
  • Ideal asset allocation is not static. Assets' performance and their correlations to each other change, so monitoring and realignment are imperative.
  • Effective diversification will include asset classes of varying risk profiles held in various currencies.

Hidden Correlation Among Asset Classes

An effectively diversified investor remains alert and watchful because the correlation between classes can change over time. International markets have long been the staple for diversification; however, a marked increase in correlation between the global equity markets has gradually been occurring in the late 20th and early 21st centuries. It began to develop among the European markets after the formation of the European Union—in particular, the establishment of the European Single Market in 1993 and the euro in 1999. Throughout the 2000s, emerging markets have become more closely correlated with U.S. and U.K. markets, reflecting the large degree of investment in and financial evolution of these economies.

Perhaps even more troubling is the increase in what was an originally unseen correlation between the fixed income and equities markets, traditionally the mainstay of asset class diversification. The increasing relationship between investment banking and structured financing may be the cause, but on a broader level, the growth of the hedge fund industry could also be a direct cause of the increased correlation between fixed income and equities as well as other smaller asset classes. For example, when a large, global multi-strategy hedge fund incurs losses in one asset class, margin calls may force it to sell assets across the board, universally affecting all the other classes in which it had invested.

Asset Class Realignment

Ideal asset allocation is not static. As the various markets develop, their varying performance leads to an asset class imbalance, so monitoring and realignment is imperative. Investors may find it easier to divest underperforming assets, moving the investment to asset classes generating better returns, but they should keep an eye out for the risks of overweighting in any one asset class, which can often be compounded by the effects of style drift.

An extended bull market can lead to overweighting in an asset class that may be due for a correction. Investors should realign their asset allocation at both ends of the performance scale.

Relative Value of Assets

Asset returns can be misleading, even to a seasoned investor. They are best interpreted relative to the performance of the asset class, the risks associated with that class and the underlying currency. One cannot expect to receive similar returns from tech stocks and government bonds, but one should identify how each fits into the total portfolio. Effective diversification will include asset classes of varying risk profiles held in various currencies. A small gain in a market with a currency that increases relative to your portfolio currency can outperform a large gain in a retreating currency. Likewise, large gains can become losses when converted back to a strengthened currency. For evaluative purposes, the investor should analyze the various asset classes in relation to their "home currency" and a neutral indicator.

The Swiss franc, which has been one of the more stable currencies since the 1940s with relatively low inflation, can be one benchmark against which to measure other currencies. For example, in a year in which the S&P 500 was up roughly 3.53% when factoring in the American dollar's devaluation against other currencies in the same year, investors would effectively experience a net loss. In other words, an investor who chose to sell his or her entire portfolio at the end of that year would get more U.S. dollars than one year previously, but the investor could buy less with those dollars than the year before relative to other foreign currencies. When the home currency devalues, investors often ignore the steady decrease of their investments' buying power, which is similar to holding an investment that yields less than inflation.

The Bottom Line

All too often, private investors become bogged down with stock-picking and trading—activities that are not only time-consuming but can be overwhelming. It could be more beneficial—and significantly less resource-intensive—to take a broader view and concentrate on the asset classes. With this macro view, the investor's individual investment decisions are simplified, and they may even be more profitable.