Last week, while taking a look at how we can better measure our success as investors, I mentioned that legendary endowment fund manager David Swensen attributed 90% of a portfolio’s performance to diversified asset allocation. Today I wanted to take a closer look at what that means, and what other factors he attributed the remaining 10% to.
David Swensen ran Yale University’s endowment fund for more than 35 years, during which time the fund saw incredible success, easily outperforming similar funds. Naturally, people were curious about what he thought were the main drivers of long-term success, and his answer may surprise you.
Instead of saying his success came down to picking the right stocks, timing the market, or some complex algorithm, he said that diversified asset allocation has the biggest influence on long-term returns. Asset allocation refers to our portfolio’s recipe: the mixture of primarily stocks and bonds. He said that asset allocation can account for up to 90% of a portfolio’s long-term performance, with security selection and market timing combining for the remaining 10%.
It’s a fascinating revelation, especially considering how much emphasis the entire globe can place on a single stock at times (I’m thinking of you, meme stocks). It’s an idea that suggests people put too much emphasis on things that don’t matter, while ignoring the things that do. Like most things in life, differentiating between the things that matter and the things that don’t feels like half the battle. But it allows us to better understand where we should focus our time.
Asset allocation
The construction of our investment portfolio is very similar to baking cookies. Instead of chocolate chips, our portfolio can be made up of a variety of different ingredients: stocks, bonds, real estate, alternatives, or cash. Asset allocation is like the recipe. It gives us the measurements of each ingredient in our portfolio, measurements that are based on our risk tolerance and financial goals. Maybe it would look something like this:
- Stocks55%
- Bonds30%
- Real estate5%
- Alternatives5%
- Cash5%
For illustration only. The right mix depends on your goals, risk tolerance and time horizon.
If you’ve ever baked cookies, you know that the recipe is just as important as the ingredients themselves. The wrong measurement of even a single ingredient can send the cookies into the trash. With investing, the same is true. A portfolio with the wrong ingredients or recipe can cause our investing strategy to be out of alignment with our goals. For example, a portfolio with too much in stocks could increase volatility (bad for short-term goals), while not enough in stocks could reduce growth potential (bad for long-term goals).
Recipes are specific. You can’t really take the ingredients and measurements from one recipe, switch things up, and expect it to be perfect for another. Asset allocation should be based on things that are specific to each of us: our goals, and what matters most to us. What works for someone else isn’t guaranteed to be right for us.
For example, let’s imagine two people who have the exact same job: the same title, income, benefits, and so on. They might look like they’re in the same situation based on that alone. But if we look past employment, they’re likely to have differences in expenses, living situation, family, dependents, lifestyle, financial obligations, retirement goals, life expectancy; the list goes on and on. So even two people who appear to be in similar situations deserve unique evaluations of what would be best for them.
The power of diversification
Diversification is the idea of not putting all of your eggs in one basket, or spreading out the risk. The more diversified our portfolio is, the more the risk is spread out, and the less impact any one asset class, industry or sector, country, or company should have on our overall portfolio. It’s a simple but important concept with investing, because it helps prolong the life of our investments. If we were to visualize it, it would look something like this:
Conceptual. Adding holdings quickly reduces the risk tied to any single company, but the market’s own ups and downs remain.
It’s important to understand that market risk is a constant. It’s the small price that we pay as investors, in the form of volatility. Above market risk, there are specific risks, tied to a concentration. It’s easy to differentiate between market risk and specific risk.
Markets naturally have flow: they move up and down, but over time much more up. Depending on the cycle that the overall market is flowing through, our investments may decrease in value. That doesn’t mean we picked bad investments, or that we are doing something wrong; it’s just a reality of investing. Market risk follows the general flow of markets, sometimes resulting in down periods over an entire year.
Specific risk (to an industry or sector, country, or company) will be much more volatile than the market. It may follow general trends, but with amplified movements. Or, due to negative events, its movement may break away from overall trends (periods of decline when overall markets are positive). If we are betting it all on one company (or a handful), our result will be tied much more to their specific returns than to the overall market.
Diversifying allows us to spread out the risk from a single company or a handful of companies to dozens, hundreds, or thousands. It puts our money in a position where we can survive some of them underperforming or even failing. It takes risk from being defined as ‘the chance I lose all of my money’ to ‘the chance I experience a short-term decrease in value’. Two extremely different things.
Investing success comes down to doing the little things right, for a very long time. Diversifying gives us the best odds of being able to invest for a very long time, and in turn gives us the best odds of being successful over that period of time.
Rebalancing
Over time, some asset classes will perform differently than others within our portfolio, causing our asset allocation to drift from its original design. In the example below, stocks and alternatives outperform, while bonds and cash underperform:
- Stocks
- Bonds
- Real estate
- Alternatives
- Cash
For illustration only. Stocks and alternatives grew faster than bonds and cash, so the portfolio now carries more risk than intended. Rebalancing brings it back to the target.
If our asset allocation drifts too far from its original design, it can expose us to too much risk. This happens in two ways:
- If we think of the law of averages, something that outperforms is more likely to come back to reality by underperforming.
- With an increased weighting to something we expect to underperform for a period, we may see increased volatility.
Drifting from our original allocation happens; there’s no way around it. But at a certain point, a rebalance should be triggered. It’s a way to sell out of something that has done really well (locking in gains), and allocate those gains to something that has underperformed (but should begin to pull its weight). Even if we don’t see a change in how the asset classes are performing, we return our expected volatility to a range within our comfort level and within our plan.
Diversification + asset allocation
Diversification and asset allocation are great things individually. But putting them together takes it to the next level; it’s like 1 + 1 = 3.
If you are well diversified within an asset class, but the allocation towards that asset class is all wrong, then it’s likely not a great investment for you. Having the perfect allocation for you is great, but if your stock allocation is made up of one company, that’s really not good. It can put you in a position where you’re exposed to too much unnecessary risk. Even in a good year, it can still be a bad thing.
To illustrate Swensen’s point, let’s look at an exaggerated example. Let’s say in a given year, bonds return 3%, stocks return 7%, and the single best investment has a return of 20%. Al invests in a diversified portfolio of 50% bonds and 50% stocks, an asset allocation appropriate for his goals. His annual return ends up being 5% ((3% × 0.5) + (7% × 0.5)).
Al’s best friend, Bob, takes a different approach. He picked the one investment that returned 20%, but his asset allocation was way off: he only allocated 10% of his funds to that investment, and the rest to bonds. His annual return ends up being 4.7% ((20% × 0.1) + (3% × 0.9)). Even though Bob got lucky and picked the best-performing stock, he underperformed Al because his allocation was off.
Diversification helps protect our investments from risk, and allows us to survive down years. Asset allocation aligns our portfolio construction with our risk tolerance and goals, so that we can get the outcome we are working towards (growing our funds, preserving our funds, or anywhere in between).
Market timing
Market timing is trying to find the perfect time to enter or exit an investment: the idea of buying low and selling high. There have been commercials about getting into a stock at the right time. We see it all the time with individual companies that are ‘going to the moon’. We can feel the constant anxiety of FOMO.
The issue is that no one really knows what’s going to happen. At any given time, a stock might go up, or it might go down. The reality is, you only really know a low or high point after it has already passed, looking back at it in your rear-view mirror.
Does market timing work?
Peter Lynch is one of the most successful investors of the 20th century. He ran a fund from 1977 to 1990 that had an average annual return of 29.2%, more than twice the S&P 500 over the same period. He put together data looking at three fictional investors who each invested $1,000 annually from 1965 to 1995.
The first had terrible luck, and always invested on the most expensive day of each year. The second had incredible luck, and always invested on the cheapest day of each year. And the third always invested on the first day of each year.
Perfect timing beat no timing by just 0.7% a year. Source: Peter Lynch’s study of three hypothetical investors.
Over the 30-year period, the first investor averaged an annual return of 10.6%, the second averaged 11.7%, and the third averaged 11.0%. Surprisingly, perfect market timing only added 1.1% over the worst market timing, and only 0.7% over no timing at all.
A recent Charles Schwab study looked at five fictional investors who each had $2,000 a year to invest over a 20-year period, from 2003 to 2022. Here’s who the investors were, and when they invested their $2,000 each year:
- Peter Perfect on the best day
- Ashley Action on the first day
- Matthew Monthly divided equally on the first of each month
- Rosie Rotten on the worst day
- Larry Linger never; stayed in cash waiting for a better time
Surprisingly, having perfect market timing didn’t provide that much more return than simply investing on the first day of each year. The study looked back at a total of 78 rolling 20-year periods going back to 1926. In 68 of the 78, they found the exact same order of results. In the other 10, investing on the first day of the year never came in last. The only real loser in the study was never investing at all. (Schwab updates this study each year; you can see the latest results on their website.)
Time in the market > timing the market
Let’s look at market timing from one final angle: additional benefit per hour. There are approximately 250 days per year that markets are open. Let’s say that before the market opens each day, our perfect market timer spends 30 minutes evaluating where things are, to decide whether to invest. Even after they make their investment for the year, they continue to spend 30 minutes gauging the markets out of curiosity (in total, 125 hours a year).
In the Charles Schwab study, the difference between perfect timing and investing on the first day of the year was $10,538. If someone spends 125 hours a year for 20 years, that equals an hourly wage of $4.22, which is 72% lower than the current minimum wage in Manitoba ($15.30 an hour). Even the difference between the best and worst timing works out to an hourly rate of only $10.30.
Looking at the results, it’s easy to say that instead of trying to time the market, it’s better to just get our money into the market. There isn’t much of a difference between investing on the perfect day each year (which is only guaranteed in hindsight) and investing immediately, or investing regularly. Financially, there’s no real benefit, and you get more time to spend on what matters most.
Security selection
What’s your guess for the percentage of mutual funds that are specifically designed to outperform the S&P 500, but actually underperform it? S&P Dow Jones Indices tracks this every year in its SPIVA scorecard, and the answer is: most of them, in most years.
Of the 22 years from 2001 to 2022, the majority of large-cap US funds outperformed the S&P 500 only twice. Mutual funds have a couple of things working against them: high fees that erode returns, and human error (the fact that we don’t know what will happen). Sometimes a strategy works, and sometimes it doesn’t. The truth is, picking winning companies is hard. There are a lot of variables outside of our control.
We don’t have to think for very long to find examples of stock picks not quite going right. We can think back recently to GameStop or Tilray. But the list of hyped-up stocks doing nothing except dropping once the vast majority of people hear about them is endless. It’s been the same story for centuries, going all the way back to the very first stock market. Even a ‘diversified mix’ of hot stocks isn’t foolproof.
Slow and steady is winning the race
2020 and 2021 were riddled with headlines questioning whether Warren Buffett and his value investing strategy were a thing of the past. Value investing, very basically, is a complex and intensive process that looks for stocks on sale. The pandemic led more people to pay attention to investing than ever before, and certain stocks saw incredible growth. The stock price of Buffett’s company, Berkshire Hathaway, was lagging in comparison. People claimed that value investing, something that has proven itself time and time again for decades, just wasn’t keeping up.
One approach that was far ahead, and maybe more popular than anything else, was Cathie Wood’s ARKK ETF, a fund made up of technology companies, crypto, and the next wave of investments. The fund saw incredible growth, building the hype and making early investors rich. But then the fund saw incredible losses. Google searches related to the fund coincided with the price peak: yet another classic example of investors chasing gains, and being the most confident in a stock when it was at its highest point.
Here’s a comparison of ARKK and Berkshire Hathaway (BRK-B) over the five years before this post:
- Berkshire (BRK-B)$18,853 (+89%)
- ARK Innovation (ARKK)$12,647 (+26%)
Month-end values with dividends reinvested, from December 31, 2018 to January 31, 2024. Source: monthly total returns for ARKK and BRK-B.
Berkshire gained more than three times as much as ARKK over that period, proving that patience is a strategy that should never go out of style. For investors who bought at ARKK’s all-time high, the price needs to more than triple just to break even. But even with this clear example, it’ll only be a matter of time before Buffett is once again cast in doubt.
Don’t get burned by a hot stock
Hot stocks can be very alluring. They are new and shiny, everyone is talking about them, and you can feel like a fool if you don’t jump in head first. But more often than not, hot stocks burn people. They take us from being an investor to being a gambler, from a place of volatility to a place of real risk of losing our money.
Markets offer returns much higher than most people typically receive, because a lot of people are invested poorly. Many stick to low-volatility, low-return options, thinking that to get great returns you need to expose yourself to uncomfortable risk. But that’s not the case. By investing smartly, we can hold all of the winners, knowing that the market goes up and the market goes down, but it goes up much more often, creating exceptional long-term returns.
I just heard this quote on a Peter Lazaroff podcast, and I think it fits in here great:
Happiness is the difference between expectations and reality.
We should expect to become rich over decades, not overnight. That should be every investor’s expectation, and it should govern how our goals and plans are laid out. If we know and understand that, then we can comfortably block out the temptation of hot stocks in favour of our tried and tested plan. Worst case of sticking to a method that works: you end up rich. Worst case of chasing hot stocks: you end up broke.
Diversified asset allocation, a secret no more
Diversified asset allocation does a few things really well for us:
- It spreads out risk across many different asset classes, industries and sectors, countries, and companies.
- By spreading out risk, it gives our money safety, ensuring that we can withstand down years and stay invested for as long as possible.
- By investing in many different things, it increases our chances of holding the winners, giving us the opportunity for great returns.
There’s often a lot of emphasis put on picking the right stocks, and picking the right timing for your investments. But in reality, timing and selection are very difficult, even for professionals. More often than not, they offer very little financial benefit over someone who doesn’t prioritize timing or selection at all. As we saw, the benefit works out to an hourly rate that’s a small fraction of minimum wage.
We can save ourselves a lot of time, energy, and headache by focusing on what we can control that will give us the most benefit possible, while ignoring the things that don’t. At the end of the day, investing is a way to work towards what we want most; it shouldn’t take us away from what we enjoy doing most. By prioritizing the right things, we can get the results we dream of, while spending less time making it happen.
Keep doing things your future self will thank you for.
