Set Your Priorities Right

When we worked for reputable investment management firms such as Morgan Stanley, Blackrock and BNY Mellon, we helped pension funds and sovereign wealth funds set up their asset allocation policy, as it was the most important source of investment returns.

In 1986, Brinson, Hood and Beebower published their seminal paper “Determinants of Portfolio Performance”. Using quarterly data from pension plans, the paper found that asset allocation explained 93.6% of the variation of portfolio returns, with security selection and market timing playing minor roles. 

While subsequent studies expanded the scope and acknowledged the importance of active management, most agree that asset allocation is essential to achieving investment goals, and should be set up as the first priority.

The same holds true for individual investors. When it comes to financial planning and retirement planning, there is nothing more essential than setting the appropriate asset allocation and adjusting it over time. 

There are two components to doing it right.

First of all, the baseline asset allocation should be set up based on an individual investor’s risk appetite, initial wealth, income projection and lifestyle expectations. It needs to be revisited at least annually to adjust for any substantial changes.

Secondly, the “timing” aspect of asset allocation has to do with insights on business cycles and volatility events. For example, when managing portfolios at Morgan Stanley, we saw the unsustainable leverage in the financial system and troubling signs early in 2008, so we decided to reduce equity exposures to the minimum. With major equity indices losing more than 50% from peak to trough, our active management around asset allocation helped to save billions of dollars for our clients.

In a nutshell, we strive to build a custom-made car for each investor in order to achieve his/her desirable financial outcome. The car should have the optimal design and horsepower, based on the individual’s unique situation and preferences. We’d then add GPS to help navigate the weather and road conditions, to ensure a smooth ride towards the goal.