The Investment Myth Surrounding the Determinants of Portfolio Performance

Almost every single person that has ever been managed by a large global investment firm has seen the chart of “Determinants of Portfolio Performance” where 92% of portfolio returns are attributed to asset allocation and NOT the selection of individual stocks or specific global markets. Financial consultants tell you that studies too numerous to count have been performed that prove the above “facts”. My question is, Who performed these studies that yielded such ridiculous results? Stasticians hired by investment firms to produce results favorable to their selling campaigns? I’m not really sure who has performed these studies and I really don’t care because I know they’re wrong and that’s all I need to know. Just like tobacco firms hired doctors to tell us that cigarettes weren’t responsible for giving you lung cancer years ago, investment firms will continue telling you certain ridiculous things that are not true as well.

In the end it’s really up to you to decide whether or not to believe all the theories they propagate and mass disseminate. I’ve stopped believing almost all their theories a long time, and ever since then, my investment returns have tripled and quadrupled. In any event, financial consultants use those aforementioned statistics to convince you that little time is necessary to spend deciding how your hard earned money is invested.

Before I started my own companies, I once heard a very successful financial consultants tell me that once I had convinced the client to turnover his or her money to me, that I should not “waste” time deciding how to invest it. Paraphrasing him, he told me to turn over the money to an outside money manager and move on to the next sale. It was a “Get ‘em in, get ‘em invested, and move on” motto. If clients knew that this type of mentality is predominant among financial consultants, I wonder if they would so quickly turn over their money to them.

What’s wrong with the pie chart that tells you 92% of portfolio returns are solely attributable to asset allocation you might ask?

The Actual Determinants of Portfolio Performance

The pie chart that is used by so many financial consultants all over the world claims that only 4.6% of portfolio performance is attributable to stock picking, 1.8% is attributable to timing, 2.1% is attributable to other (I’m not sure what is in the “other” category, maybe planet alignment and sun flares), and that 91.5% of your portfolio returns are determined by asset class allocation only. If this were true, then of course it would not make sense to demand that your financial advisor spend more than thirty minutes deciding how to allocate the USD $1,000,000 you just gave him. If this were true, then once a financial consultant had decided what asset classes to allocate one client in, then every subsequent new client, whether he or she had $500,000 or $10,000,000, could conceivably be invested in exactly the same asset classes at least for the next six months. And this is exactly what the overwhelming majority of financial consultants do.

However, from a strictly logical perspective, does this theory make even the slightest sense to you? Do you really think that if you owned the five companies with the best management in the industry, that their share performance would be comparable to the five companies with the worst, bumbling, shortsighted management teams, merely because they were in the same asset class? If a business has forward sold contracts at the wrong time or if a business has not hedged against foreign currency exchange risk, this could be the difference between a profitable company and a losing one. Yet financial advisors always claim that it doesn’t really matter what individual stocks you own as long as you own the right asset classes. What if technology is tanking in the United States but booming in India? Well the above pie chart tells you it doesn’t matter regionally where you are invested as long as you are invested in the proper asset classes.

People whose portfolios have been overweighted in Asia for the past five years and that have returns 100% to 200% higher than those concentrated in the U.S. will tell you that being invested in the correct regional markets creates substantial differences in results.

Performance in stock investing is 100% about investing in the right companies at the right time in the right countries. No ifs, ands or buts. Don’t ever be misled again by the crazy notion that timing is irrelevant, regions are irrelevant, and individual companies are irrelevant.

In my mind, the only reason that the most cited “determinants of portfolio performance” pie chart holds so much credibility is because it has been cited so often without any credible discussion regarding its deep flaws. As any war historian will tell you, tens, if not hundreds of millions of people believe erroneous “facts” about wars because they have been taught wrong information in schools that has been reinforced numerous times over many years. Ask people about critical factors surrounding WWI, WWII, the Vietnam War, and in contemporary times, even the Iraqi War, and most people will get some facts twisted because they had read an erroneous report somewhere. Just because millions of people believe something does not make it true.

Instead of being called “Determinants of Portfolio Performance”, the chart most widely known by investors should be renamed “Determinants of Asset Gathering”

The lesson to take away from this is as follows: To build wealth through investing, seek someone that is a (1) a superior stock picker; (2) is very knowledgeable about global markets and is knowledgeable about regional trends; and (3) is knowledgeable about enough technical indicators to utilize market timing to your advantage. Again, I will always contend that this “someone” should be the person that stares back at you every morning when you look at a mirror.

This article may be freely reprinted on another website as long as it is not modified, changed, or altered in any way and as long as the below author byline is included along with the active hyperlink exactly as is.

J.S. Kim is the Managing Director of SmartKnowledgeU™. He has over thirteen years of experience in finance and financial services, and has earned a BA in Neurobiology from the University of Pennsylvania, a Master in Public Affairs from the University of Texas at Austin, and an MBA with a concentration in finance from the McCombs Business School, University of Texas at Austin. He is the inventor of the revolutionary MoneyPing™ investment strategies, a novel approach to learn advanced wealth planning techniques, and how to build wealth, not just dreams.

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