It has been reported that Depression era gentleman robber, Willie Sutton, was asked by the FBI why he robbed banks. His revealing answer is still germane: “Because that’s where the money is.”
When you are investing, you want good returns. Everyone wants good returns – and different than Mr. Sutton – to do so legally. Notwithstanding that desire, people have little understanding of exactly where their returns come from, a shortcoming in knowledge that persists among even the more experienced investors. This month’s letter delves into that subject and because of its obvious importance, becomes point #6 in the Top 7 steps needed to be financially successful.
The subject of investment returns can be immensely complicated. Very unfortunately, the subject is also intensely debated because of the competitive nature of the industry and different money managers who are seeking your family’s dollars (generally being institutional fund managers, but they can be individual brokers if they proclaim stock picking expertise). Notwithstanding the cacophony of noise caused by these sources, let me assert that the answer is Asset Allocation – the prime determinant of your investment returns is an outcome of your selected Asset Allocation. Said a little differently, how much return you can expect on your portfolio is directly related to how much of your money you have in Cash (x), how much you allocate to Bonds (y), and what proportion you have in Stocks (z). The total allocation of your portfolio must equal 100%, the x + y + z variables being the percentage dollars allocated in each of those 3 categories.
Lest I give the false impression that the above is easy to understand and instruct, let me disabuse you of that notion. I said above the topic is complicated. One small reflection of that reality is that you have 80,000 different securities in the world that must be fitted into one of those three variables. Trade-offs in categorizations have to be made, and then there’s the inconvenient truth that Asset Allocations themselves are comprised of 138 different institutional asset classes. Still, in spite of this investment smorgasbord, let me site 3 foundational academic papers that you could read to understand the nuances to the importance of Asset Allocation.
- In a seminal1986 study, three researchers concluded that 93.6% of all the variation in returns between portfolios was due to their asset allocation (Gary Brinson, L. Randolph Hood, and Gilbert Beebower, “Determinants of Portfolio Performance”, Financial Analysts Journal, July / August,1986).
- Roughly 15 years later, a study was conducted to not look at simply variations in annual portfolio returns, but in the returns themselves. They concluded that these base allocations made up close to 100% of returns (Roger Ibbotson, Robert Kaplan, “Does Asset Allocation Policy Determine 40, 90 or 100% of Performance”, Financial Analysts Journal, January / February, 2000).
- Then in the beginning of the last decade, Roger Ibbotson gave it a parting shot with his concluding observation that the old Warren Buffet saying of “a rising tide lifts all boats” was 75% of the answer (general market movement), with the idiosyncrasies of specific institutional asset allocation and active management (R-squared value dependent for you statisticians) splitting the remaining attribution balance (Roger Ibbotson, “The Importance of Asset Allocation”, Financial Analysts Journal, March / April, 2010).
The penultimate insight to understanding how returns work is to grasp the reality that human beings are not rational in investing, but they SEEK TO BE rational. Thus, finance research proves (and we instinctually accept) 3 supplemental pieces of data that solidify the importance of Asset Allocation.
- Risk = Return. As investors, we are NOT going to hold wildly fluctuating stocks until they give us more return than cash. The commonly accepted ‘risk free’ rate of return in the world is the 90-day Treasury Bill. This difference in high finance parlance is called the “Equity Premium”. It must exist.
- Bonds (lending money to some corporate or sovereign entity) is certainly risker that 90-day Treasury Bills backed by the full faith and credit of the U.S. government, but not as risky as stocks because they are backed by debt collateral (whether company printers, Prius’ or patents). Thus, their expected annual returns must be somewhere between cash and stocks, and at 4%-6% per year, it is[i].
- Prices adjust. There is always and everywhere an ‘equilibrium price’ for any security. If investors thought the underlying worth of a stock was more than it’s currently traded for…it would be bid up in price until it achieves that deemed equilibrium price (also called the clearing price). If we thought that Humpty Dumpty Corporation was worth less than it was trading for, then we would sell, and the price of that stock would fall. For this reason, the ‘Active Management’ of portfolios was mathematically destined to be a fool’s errand 30 plus years ago as established by a future Noble Prize in Economics awardee[ii] and it has indeed fallen short in every 5-year rolling period since then[iii].
Combining all of the above, you are left with the conclusion that if you want to know where returns lie in the future, you have to position yourself to wisely take the right amount of risk to get you the returns you want. You have to be patient, but you’ll get the rewards you want and deserve. Forget about Willie Sutton who took too much monetary risk and paid for it with time in the pen. Think instead about your investments like the great NHL star Wayne Gretzky thought about hockey: “I skate to where the puck is going to be, not where it has been.”
It remains my deep and distinct honor to serve you well.
Patrick Zumbusch
Founder and CEO
[i] “2025 Corporate Bond Outlook” (Colin Martin, Markets and Economy, Schwab.com, December 5, 2024)
[ii] “The Arithmetic of Active Management” (William F. Sharpe, Financial Analysts Journal, January / February, 1991)
[iii] Standard and Poor’s Versus The Indices (SPIVA, June 30, 2024)
