Investment Returns: Asset Allocation With An Equity Bias
Welcome to the Alternative Wealth Podcast, where we unpack important personal finance, investment, and retirement topics so you have the knowledge to make critical decisions regarding your wealth. I'm your host, Ryan Kolden. Let's get into it.
Today, we're going to dive into the world of investment returns, specifically asset allocation and how long-term investors can be rewarded by constructing a portfolio with an equity bias. We'll review the main drivers of investment returns, historical data for wealth multiples broken down by asset classes, showing how investors with an equity bias are rewarded in the long run. Then we'll explain how you can use this information to construct a portfolio to achieve your financial goals.
So generally speaking, investment returns stem from three portfolio management tools. The first being asset allocation, the second being market timing, and lastly, security selection. And asset allocation is the practice of defining asset classes such as stocks, bonds, real estate, and other alternative investments that make up the portfolio, and identifying how much of an investor's capital should be used to fund a specific asset class. Now, Roger Ibbotson is among one of the best known scholars when it comes to asset allocation. In a 2000 study done by Ibbotson and Paul Kaplan, titled, Does Asset Allocation Explain 40, 90, or 100% of Performance? They concluded that 90% of the variance of a portfolio is explained by its asset allocation policy. So just to reiterate, Ibbotson and Kaplan found that asset allocation accounts for the bulk of a portfolio's return.
However, Yale's renowned chief investment officer, David Swenson, He makes the case in his book, Pioneering Portfolio Management, that it isn't really the asset allocation that is the central determinant of a portfolio's return. Rather, it's investor behavior based upon which tools of portfolio management that they decide to use as their predominant strategy, whether that be the strategy of aggressively day trading or picking a single security. Now, Swenson then goes on to make the case that it's incredibly challenging to succeed long-term with timing the market or selecting winning securities. So that kind of leaves the only tool for investors to drive returns through asset allocation. So if we logically say that we aren't going to win by timing the market or by picking individual securities, then that leaves us with asset allocation being our primary portfolio management tool. the tool that we can control to drive investment returns. Now, in return, this reduces the degree to which investment returns are dependent on outside uncontrollable forces.
Now that we know that asset allocation is a sensible place for us to focus our time and efforts to drive returns, the next question that brings us to is how we should, as investors, allocate our capital to preserve our principle and grow it for the long run. And we can answer that question by looking at some historical data collected by, again, Roger Ibbotson and Rex Sinkfield. So here are some wealth multiples for various US asset classes from December 1925 to December 2005. So inflation has a 11 times multiple. Treasury bills, 18 times. Treasury bonds, 71 times. Corporate bonds, 100 times. Large cap stocks 2,658 times and small cap stocks 13,706 times. So if we take the treasury bond example, which had a multiple of 71 times, the data indicates that a single dollar invested at the end of 1925 and with all the income reinvested would have grown 71 times by the end of 2005. And if we compare that 71 times multiple to common stock or to owning large cap stock, that difference is magnitudes of a difference of significance. So by owning common stock, your dollar would have multiplied 2,658 times by the end of 2005. What I want to take away from this is the magnitude to which an investor benefits in the long run by accepting greater equity risk in their portfolios. And although we looked at a timeframe of about 80 years, if we went ahead and extended out that timeframe even longer, what you would find is that the results would be even more dramatic, allowing one to conclude that investors can maximize their wealth in the long run by investing in equities rather than buying strictly debt securities.
Now, the final piece that I want to discuss is that although historical data shows that investors win in the long run by having an equity biased portfolio, the value of equities can be extremely volatile in the short term. If you were to bias yourself into a single asset class, you know, such as just being in stocks or just in bonds, you introduce an extreme amount of risk into your portfolio. And this risk can be combated by diversifying your portfolio across many assets. And the important part here is many assets, not just one asset class, not just two asset class, but several asset classes. Now the specific asset classes and their weighting is going to depend heavily on an individual investor's goals and needs. So unfortunately, I can't give you a specific thumb rule to use. However, true diversification comes from the inclusion of multiple asset classes. Again, not just stocks and bonds. It can include many other asset classes such as real estate, private credit, natural resources, and private equity. And the reason we do this, it gives the different asset classes the opportunity to respond to different forces that drive the markets and ultimately build a much more efficient and resilient portfolio.
So today we covered that investors can set themselves up for long-term success by focusing on asset allocation and constructing their portfolios with a strong equity bias, as well as diversifying their portfolio amongst many different asset classes in order to mitigate those risks associated with security selection as well as market timing. Hope this provided some context on how you can construct a portfolio. and help you achieve your long-term goals.
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The opinions and views expressed here are for informational purposes only and is not tax, legal, financial, investment, or accounting advice. This material is educational in nature and should not be deemed as solicitation of any specific product or service. All investments involve risk and a potential for a loss of principle. Should you need such advice, please consult with a licensed financial, tax, or legal professional. Neither host nor guest can be held responsible for any direct or incidental loss incurred by applying any of the information offered.
