90% of investment returns are driven by asset allocation… Or are they?

Many investment houses often tell clients “Asset allocation is responsible for 90% of investment returns.” So, is it true or is it a myth?

I’ve worked through a number of scientific studies – and I believe that I can answer this question for you.

Why Asset Allocation isn’t the be-all and end all of investment returns

The claim that 90% of investment returns are from asset allocation is a myth that started from misquotes and misrepresentations of a study done in the UK in the 1980’s.

The Determinants of Portfolio Performance research carried out by Brinson, Hood and Beebower and published in the Financial Analyst Journal in 1986, found that the percentage of the variability of a portfolio’s return over time that could be explained by asset allocation policy was over 90%.

But you see – this study talks of the ‘variability of return’ not the return itself.

What this means is that differences in asset allocation explain the majority of the difference in the return of pension fund A compared to pension fund B.

But a later study in the 2000’s found that the actual returns of pension fund A compared to pension fund B are mostly attributable to the actual returns on the stock market.

At the end of the day – if the stock market does badly your portfolio will do badly. And if the stock market does well, your portfolio will do well.

Asset allocation will only be responsible for how bad, or how well your portfolio does in these years.

But this still doesn’t mean you shouldn’t focus on asset allocation. It simply means that asset allocation is only responsible for SOME of your investment performance (studies now show around 40% of returns).

The truth is, there are a number of things you HAVE TO FOLLOW to ensure optimal returns.

Here’s how to invest to get the highest portfolio returns – with the lowest risk possible

Making good returns from investing means you want to make the most money by risking as little as possible.

But in conjunction with this, there are a number of other things you have to do to sustain high portfolio growth:

Portfolio Growth Factor #1 – The amount of money you save: If you don’t save money you have nothing to invest with. The more you save, the more you can invest. And the higher your potential returns will be. So you need to go have a look at how much you can afford to save right now – and if possible increase that amount each month.

Portfolio Growth Factor #2 – The length of time you let it compound: You need to give investments time. It’s not much use starting to invest at age 60, and hoping to make a fortune by 65. Then you’re hedging your future on luck. The only true, nearly guaranteed way to ensure prosperity is to invest from as young as possible, and for as long as possible.

Portfolio Growth Factor #3 – Your asset allocation: Where do you invest your money? Some investors put everything in property. Others are risk averse and stick everything in a bank savings account. The more adventurous want to put their life savings on the line investing in penny stocks and crypto currencies. None of these options will serve you in the long run. You need to have your money in more baskets than one. Invest in the stock market. Invest in property. Invest in fixed income investments like bonds and the money market. By allocating money to different investment classes, you ensure smoother returns. In years, the stock market struggles your money market fund will pay off. When interest rates are low, shares will give you good returns… In a moment – I’ll give you a model to follow for asset allocation. But first, the remaining three factors that influence your investment returns.

Portfolio Growth Factor #4 – Your investment selection: Obviously – there’s no use in following the first three rules and then still picking only losing investments. So your investment selection has to be a successful strategy. When picking winning shares I stick with proven strategies and investment criteria. Financially sound companies with track records of growth and the ability to weather storms.

Picking the right kind of shares mean that your investments outlast forecasts and investment ‘trends’. When investing in properties you don’t want to put money in property that doesn’t give you a return from day one.

Similarly, you won’t put your cash in a Zimbabwean bank account, but rather one in the UK, US or Euro-zone.

Portfolio Growth Factor #5 – The expenses you absorb: Too many investors completely ignore investing costs.

That’s a big mistake. If you pay 2.5% fees on a R1 million portfolio that’s R25,000 in a year. If that portfolio grows 10% this year and you pay the same 2.5% again, your fees come to R27,500 in year two. In this example, you’d pay R1.716 million in fees over 20 years.

If you only paid 1% fees on your investments you’d save more than R1 million over that period and your investment will have grown by more than R1.1 million more – without the need to invest a cent extra.

Portfolio Growth Factor #6 – The taxes you pay: If you continually buy and sell shares, you attract income tax on your returns. That means high taxes. If you hold shares for a longer period, you attract capital gains tax – which means a lower tax burden. Then there are a range of other tax benefits you can take advantage of as an investor.

Section 12J is a tax benefit where you can write off your ENTIRE investment against your income tax (only applicable to specific kinds of investments). Or the tax benefits you gain by investing in retirement annuities and pension funds. Don’t ignore taxes when you invest – they could eat away at your hard-earned returns.

In short – if you want to grow your investment portfolio in a few years, save as much as possible. Keep your money invested. Spread it out in different investments – and pick good investments. Minimize your expenses and taxes.