Three asset classes - stocks, bonds, and cash make up the investable universe of all assets. How investors choose to allocate their investment dollars across these classes can have a significant impact on the long-term return of an investor’s portfolio. The decision to hold stocks, bonds or cash and in what amounts is believed to account, on average, for the bulk of the variation (risk) in an investor’s return. For a given investor, determination of the optimal mix is what is commonly referred to as an investor’s investment policy or asset allocation policy. It is also known as the asset mix, investment mix, and asset allocation for short.

A capital investment or equity ownership in an entity, commodity or enterprise is represented by holding an ownership certificate, stock. Equity investors earn a return premium that compensates for the perceived level of risk relative to the two other asset classes (bonds and cash). Equity ownership is indefinite, i.e. return of income is uncertain. Bondholders are lenders and they purchase debentures (debt contracts), in the form of bonds, and lend cash for a predetermined period of time. In return for lending their money, bondholders earn a rent, or rate of interest on the principle balance lent. Investors in cash earn the equivalent of a risk-free rate of return on their money. Stock and bond investors typically earn a risk premium, the rate of return above the risk-free rate that an investor demands for assuming risk. The rate of return on a risk-free investment, short-term (overnight) lending, is usually equal to or less than the rate of inflation.

A risk asset is an investment whose real (inflation-adjusted) return and the safe return of principle is uncertain. On the scale of least risky to most risky, cash is least risky and stocks are viewed as most risky. This is because stockholders are second to creditors, lenders of money, in the return of capital. Bondholders get paid before shareholders. As a consequence, shareholders demand higher rates of return to bondholders and bondholders earn higher rates of return to cash investors (who face virtually no insolvency risk). Portfolios made up of different proportions of stocks, bonds and cash will vary in return and risk (defined as the variance in return). There is a tremendous difference between a portfolio whose mix is 80% stocks, 15% bonds, and 5% cash and one whose mix is 60% stocks, 30% bonds, and 10% cash.

Typically, investors are characterized as either passive or active. Passive investors construct their portfolios by buying and holding a collection of randomly selected securities, a diversified portfolio. Investments are purchased with the intention of obtaining long-term appreciation and limiting turnover and maintenance. Passive management is better known as indexing, the designing of a fund to mirror the performance of a published benchmark. Unlike passive management, active portfolio management attempts to add value through one of two active strategies, market timing or security selection. Market timing is an attempt by an investor to benefit from the divergence of the current value of an asset from its “correct” or “rational” level. Security selection attempts to add value by purchasing undervalued (mispriced) securities or emphasizing a group of securities that make up an investment theme, i.e. small capitalization over large capitalization stocks. The objective with active management is to produce better returns than those of passively managed index funds. It has been demonstrated that active management detracts more often than not from overall portfolio performance; that asset allocation plays a more important role in overall portfolio performance.

Over the years, there has been considerable debate as to the importance of an investor’s asset allocation policy. In 1986, Brinson, Hood, and Beebower (BHB)[1], three knowledgeable investment management practitioners, studied the performance of ninety-one large U.S. pension plans over the 1974-1983 period and concluded that “investment policy (asset allocation) dominates investment strategy (market timing and security selection), explaining an average of 93.6% of the variation in total pension plan returns”. Others (most notably Jahnke[2] and more recently Kritzman[3]) have argued that BHB’s original conclusions and methodology are flawed. They contend that too much importance is given to asset allocation; that market timing and security selection have been marginalized.

Without getting into the specifics, Modern Portfolio Theory describes markets as efficient (all publicly available information on an asset is incorporated in the asset’s price nearly instantaneously). If one believes markets are informationally efficient, then it would be difficult to add value from active management. The certainty of market efficiency has been brought into question by some market practitioners, and thus as well, the relevancy of asset allocation. With little uncertainty, suffice it to say that we can probably ascribe efficiency to markets over the intermediate to long-run, which after all is what we should be concerned with as investors. Conventional wisdom accepts that for the “average” investor (especially the unsophisticated investor) it is very difficult to beat the market (earn a rate of return greater than the risk premium associated with an amount of risk). As well, it has been proven, again Modern Portfolio Theory, that in the case of a specific asset class (for instance, stocks), an investor does well to invest in a diversified portfolio.

In my experience, unsophisticated investors (those who do not make a career out of stock picking) are far off better focusing on the asset allocation decision than worrying about which stocks or bonds to hold (security selection) or when to buy them (investment timing). It is clear from financial theory and practical experience that investors’ asset allocation choices should be linked with their specific circumstances or long-term financial goals. Investors determine their asset allocation policy based on their risk tolerance, their financial goals, their time horizon, their non-financial wealth (such as employment income), and the risk premiums of the asset classes.

That is not to say that certain individuals using superior research or first-hand experience cannot take advantage of unique information from time to time through active portfolio management (trading). However, it is likely that the knowledge will become known by the rest of the market, or as well, be in the possession of others, and therefore in the long-run not have any intrinsic value. Only if investors have the ability to predict expected returns in financial markets can tactical (active management) asset allocation enhance portfolio performance. Keep in mind that the degree of skill required to justify an active management strategy is very high. Investing on the basis of event driven information (such as earnings releases or change in corporate control), which may materially impact the value of an enterprise, is likely to be viewed as insider information and construed as illegal.

A better way to consider this issue is to determine whether or not having better information about the asset changes its risk profile and thus the willingness of an investor to assume risk. If so, an investor should be willing to increase such holdings in his/her portfolio. As an investor becomes more knowledgeable about the ownership of equities and more comfortable with their risk, he would then consider increasing his allocation to equities, presuming the allocation meets his risk tolerance.

A passive investment strategy (no trading) with rebalancing (resetting the asset mix to meet your specific circumstances related to return objectives and risk tolerances) is likely to incur lower costs to manage than active portfolio management (buying and selling assets based upon market timing and security selection). The BHB study found that, on average, tactical asset allocation (market timing) and security selection work to detract 1.1 percentage points from the return that would have been achieved with strategic asset allocation (a passive investment strategy) alone. Depending upon one’s time, commitment, and experience, he/she might be better off creating a diversified portfolio of stocks or bonds by choosing to use exchange traded funds (ETFs) encompassing a basket of assets that replicate a “market” portfolio.

In the BHB study, it was found that a portfolio’s asset allocation policy dominates portfolio performance, and over a period of time typically explains over 90 percent of the variation in the portfolio’s returns. However, that is not to say that within a given portfolio’s return, active management did not play a role in imparting a return that varied significantly from a portfolio benchmark. The average ten-year annual return of the 91 actual portfolios was 9.01% and ranged from 5.85 percent to 13.4 percent. Portfolios yielding returns in excess of the average in all likelihood may have been attributed to superior skill or knowledge. As well, they were likely to have been far and few between; the exception. In the long-run, due to competitive forces, the benefit of skill and predictability will average out - losing as often as winning and reverting returns to the mean. Financial theory and empirical evidence show that exposure to systematic risk (market risk) is compensated over time. Active management risk is not compensated on average (Sharpe, 1991)[4]; however, it is compensated if skill overcomes the higher cost hurdle of active management. Active management creates opportunity to outperform. However, the most important consideration is how much extra return active management can add without exposing the portfolio to unwarranted risk. Overcoming the higher cost hurdle of active management is a challenge.

As L. Randolph Hood, the “H” in BHB, stated in a letter to the Financial Analysts Journal 20 years hence first publishing their findings in 1986, “Our message today remains the same as before: Carefully consider what goal you are trying to achieve, how important it is to achieve it, and how much risk you are willing to tolerate in pursuing it. Then, create a policy portfolio (a portfolio allocated to the three major asset classes - stocks, bonds, and cash) that reflects that goal and your risk tolerance for probable outcomes - because executing that policy will have a dominant effect on your success.”[5] Investment policy (the asset allocation decision) should be addressed carefully and systematically.

[1] Brinson, Gary, Randolph Hood, and Gilbert Beebower. “Determinants of Portfolio Performance.” Financial Analysts Journal, July-August 1986, pp. 39-44.

[2] Jahnke, William. “The Asset Allocation Hoax.” Journal of Financial Planning, February 1997, pp. 109-113.

[3] Kritzman, Mark. “Determinants of Portfolio Performance-20 Years Later”: A Comment. Financial Analysts Journal. January/February 2006, Vol. 62, No. 1: 10-11.

[4] Sharpe, William F., 1991. “The Arithmetic of Active Management.” Financial Analysts Journal 47 (1): 7-9.

[5] Hood, L. Randolph, CFA. “Determinants of Portfolio Performance - 20 Years Later.” Author’s Response. Financial Analysts Journal. September/October 2005, Vol 62.

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The opinions and views expressed in this article do not necessarily reflect the views of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Before you all start rolling your eyes at me for stating the obvious, hold on and hear me out.  It is one thing to say don’t lose money, it is quite another to do it.  Long-term investment success depends on not losing, i.e. not taking major losses.  If you focus on the downside (risk), the upside (profit) will take care of itself.

Too often investors get caught up in the thrill of victory focusing their attention on big gains and “making a killing” in the market.  Slow and steady wins the race.  Speed kills. Even though we know that accidents most often happen to drivers that are speeding and going too fast, the allure of fast money and the quick buck can lead to straying from a disciplined investment approach and taking long shot wagers.  When this happens, you have left the realm of investing and entered the arena of gambling (speculation).

Large losses are forever. A 50 percent loss requires a doubling in value of the asset just to get back to even. Ask yourself, how often have you known an asset to double in value and in what time frame? It takes roughly seven years for an investment to double in value earning a 10% annual return. By avoiding large losses (play defense), the winnings will have every opportunity to take care of themselves. Manage your downside. Play good defense. Avoid big mistakes. In investing, as in sporting competition, learn to cut your losses (eliminate mistakes) and the winners will follow.

In an article published in the Financial Analysts Journal (1995), “The Loser’s Game,” Charles D. Ellis writes convincingly about the inability of professional money managers to “beat the market.”[1] He sites a study conducted by an eminent scientist, Dr. Simon Ramo of TRW.

Ellis writes, “Simon Ramo identified the crucial difference between the Winner’s Game and the Loser’s Game in his excellent book on playing strategy, Extraordinary Tennis for the Ordinary Tennis Player. Over a period of many years he observed that tennis was not one game but two. One game of tennis is played by professionals and a very few gifted amateurs; the other is played by all the rest of us.

After extensive scientific and statistical analysis, Dr. Ramo summed up his findings this way: Professional tennis players win points; amateurs lose points. Errors are seldom made by professional players. Expert tennis is what Ellis calls a Winner’s Game because the ultimate outcome is determined by the actions of the winner. On the other hand, the amateur duffer seldom beats his opponent, but he beats himself all the time. The victor in this game gets a higher score than the opponent, but he gets that higher score because his opponent is losing even more points. Professional tennis is a Winner’s Game - the final outcome is determined by the activities of the winner - and amateur tennis is a Loser’s Game - the final outcome is determined by the activities of the loser.

The ordinary player can win games and matches again and again by following the simple strategem of losing less, and letting the opponent defeat himself. The way to avoid mistakes is to be conservative and keep the ball in play, letting the other fellow have plenty of room in which to blunder his way to defeat. An opponent who tries to win a losers game will try to beat you by winning, but he is not good enough to overcome the many inherent adversities of the game itself. The situation does not allow him to win with an activist strategy and he will instead lose.”

This unfortunately is the same situation you face as an investor. In the long-run, you can not win with an activist strategy (market timing/security selection). Sure, every once in a while you will play a “hunch” and be rewarded, but this will only foster a false sense of confidence in your ability to repeat your good fortune. That is a trap and will come back to haunt you. In time your efforts to “win” will only increase your error rate. Over time you will start to underperform the market. This is how the ordinary investor loses in the Loser’s Game. According to Ellis, Ramo instructs in his book, the strategy for winning the Loser’s Game is to lose less. Avoid trying too hard (or in the case of the market, invest in an index fund that correlates well with the market and avoid trading, i.e. timing the market). In brief, as Ellis puts it, by losing less become the victor. If you can’t beat the market, you certainly should consider joining it. An index fund is one way.

Five Ways to Win the Loser’s Game:

1. Know Thy Self. What are your financial objectives? Are they achievable and realistic given your tolerance for risk? What is your risk tolerance? Can you stomach short-term fluctuations in wealth to achieve long-run investment success? Are you willing to put forth the work needed to be successful? Do you have the necessary skills and know-how to be a winning investor.




2. Define Your Long-Run Objectives: Set wealth goals. What are your financial needs? How much income will you need in retirement? Are you saving to provide for your children’s college education? Do you have the discipline and patience to pursue a long-run investment strategy? Plan the race that is right for you. Run your own race to achieve your own realistic objectives.




3. Do Not Try to Beat the Market: Forget about the notion of beating the market in the long-run. At best, you can hope to replicate the performance of the market. How do you expect to beat the market when it is made up of so many professionals? Professionals armed with vast resources. More resources than you can ever hope to have. Eventually, if you own enough stocks and hold a diversified portfolio, you will be the market, i.e. you can expect your portfolio to generate market returns. Oh yeah, every once in a while you will have a winner that makes you think you’re smarter than everyone else and that you can earn out-sized returns (get rich quick). Just remember, a baseball player with a .200 batting average will hit a home run every once in a while as well. That doesn’t mean he all of a sudden has acquired the skills to be a .350 hitter.




4. Diversification: Countless academicians and investment professionals have confirmed and endorsed the benefits of diversification (spread your risk over many bets; don’t put all your eggs in one basket). Stock portfolio (a portfolio made up of individual stocks) diversification can be achieved through the random selection of a number of stocks (usually 30 or more on an equally dollar weighted basis).The primary benefit of diversification is that for a given amount of risk, investors can expect to achieve a higher rate of return from an efficiently constructed portfolio (where the holdings in the portfolio are sufficiently uncorrelated). The basic concept that an investor can reduce portfolio risk simply by holding instruments which are not perfectly correlated (diversified) derives directly from the principles of Modern Portfolio Theory.




5. Have an Investment Policy: Investment policy (or more commonly, asset allocation - the division of investable funds among investable assets i.e. stocks, bonds, and cash) has been shown to account, on average, for 93.6% of the variation in total return in a sample of portfolios (corporate pension plans) studied.[2] In the past, criticism was directed at the study - or more accurately, its interpretation by the industry - and raised doubts about its applicability to general investors. Twenty years since being published debate continues over the importance portfolio policy (asset allocation) plays in the construction and subsequent performance of an individual’s set of investments. However, it would be hard to find any investment professional who would disagree with the notion that the initial decisions made regarding portfolio policy will play an important role in the outcome of any long-term investment strategy.

The market is dominated by institutional investors. Consequently, investing today is a Loser’s Game. You can’t win at investing by trying to “beat the market.” You simply must avoid losing.

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[1] “The Loser’s Game,” Charles D. Ellis, Financial Analyst Journal / January-February 1995: 95-100. Reprinted from FAJ (July/August 1975): 19-26.
[2]” Determinants of Portfolio Performance,” Gary P. Brinson, L. Randoph Hood and Gilbert P. Beebower, Financial Analysts Journal, (July/August 1986):39-44.

The opinions and views expressed in this article do not necessarily reflect the views of InvestingMinds.   InvestingMinds did not prepare and does not endorse such content.  Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments.  No part of this document may be reproduced in any manner without the written permission of InvestingMinds.