Commentary by Todd Schlanger, an investment strategist with Vanguard Investment Strategy Group.
With so many potentially market-moving events happening, investors might be tempted to make short-term changes to their portfolios. To help combat this temptation, I thought it might be a good time to revisit the importance of strategic asset allocation.
Long-term allocation for long-term goals
We often use investment portfolios to meet a specific future need – such as to save for retirement or for a child's education. The long-term nature of these goals means that it's crucial to take a strategic, disciplined approach.
In landmark research from 19861, researchers found that broadly diversified balanced funds with limited market timing tend to move in tandem with overall financial markets. Therefore, these broadly diversified portfolios' static equity/bond mix targets, or strategic asset allocations, explained the majority of the variation of returns. A recently updated study conducted by Vanguard with data running to 31 December 2015 found similar results.
The main driver of returns
The figure below summarises our findings. In Australia, for example, strategic asset allocation explained 89.1% of return variation, suggesting that a portfolio's investment policy is by far the most important contributor to return variability. Tactical asset allocation (also known as market timing) and stock selection on the part of actively managed funds explained the remaining 10.9%. However, it's important to note that, on average, these activities detracted from performance. Other markets had similar – and in many cases even more compelling – results.
Role of asset allocation policy in return variation of balanced funds
Selected periods, January 1990–September 2015
Sources: Vanguard calculations, using data from Morningstar, Inc.
Start with your strategic asset allocation
Given the importance of strategic asset allocation, we believe that it should be the first consideration in the portfolio construction process, before turning to individual fund selection. And in the fund selection phase, we believe investors should start by considering the returns available through low–cost passive solutions, before considering active strategies. Investors can determine the right blend of passive and active based on their risk and return expectations.
Remove the temptation
Strategically allocated funds that rebalance back to their target weights – such as Vanguard's Diversified Funds – can be a good way of protecting investors from the potentially harmful temptation to tinker. In a recent post, my colleague Nick Blake discussed the strong positive performance of the LifeStrategy funds (the UK equivalent of the Diversified Funds) on 24 June, the day following the Brexit vote. Two factors drove performance, the strong performance of high quality bonds and the global diversification of the funds aided by sterling's weakness.
In hindsight, both of these factors seem entirely rational, but that doesn't mean that they were easy to predict. In times of uncertainty, things can move quickly and investors don't always make rational decisions. In this case, discipline paid off with a positive return in a period of market stress. The LifeStrategy Funds did what they were designed to do – namely, staying on track with their strategic allocations, rebalancing to those allocations as necessary and ignoring market noise.
1 Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower, 1986. "Determinants of Portfolio Performance". Financial Analysts Journal 42(4): 39–48; reprinted 1995 in Financial Analysts Journal 51(1): 133–38.