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Most stock brokers talk about the advantage of an asset asset allocation strategy which allocates portions of your portfolio to classes of investments (stocks, bonds, cash, large cap, small cap, international etc.) and re-balancing periodically as one class outperforms another and you become over-weighted in it. I found that re-balancing each year got a 0.5-1% / year improvement over a buy and hold strategy and some of this would be eaten up in commissions.

Is it possible that brokers are touting the advantage of re-balancing to get more commissions?

In a landmark study, Determinants of Portfolio Performance , published in the Financial Analysts Journal (July-August 1986), Brinson, Hood, and Beebower examined the investment results of 91 very large pension funds to determine how and why their results differed.

They determined 94% was due to Investment Policy, 4% stock selection and 2% market timing.

Investment policy was defined as the average base commitment to three asset classes. stocks, bonds, and cash.

You allocated a percentage of your portfolio to each class and as the value of one class went up you rebalanced your portfolio moving assets from the class that went up to the lower priced class. (i.e. sell high, buy low).

In the Jan/Feb 2001 issue of the Financial Analysts Journal, Ibbotson and Kaplan published Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? . They used 5 asset classes: large-cap US stock, small-cap US stock, non-US stock, US bonds, and cash. They confirmed that over 90% of the return was due to asset allocation.

Ken Fisher. Stock guru, says that 70% of long-term portfolio returns are attributable to basic class asset allocation (stocks, bonds, cash), 20% can be attributed to sup-asset allocation (larage/small cap, growth/value, foreign/domestic) and 10% to indidividual security selection.

Everyone has stories of how Aunt Millie made fortune by investing in IBM. And we like to talk about how we bought cisco in 1990, but no one talks about buying MCI in 1999. There’s nothing wrong with setting aside part of your portfolio for stock picking, but you may not want to gamble your retirement on picking the next Wal-Mart.

In Asset Allocation in Investment Strategies for the 21st Century at InvestorSolutions.com Frank Armstrong says:

Today, the asset-class decision is more complex than just a decision on stocks, bonds, or cash. Literally hundreds of separate and distinct asset classes could be identified, and more are constantly being proposed. Each has different combinations of risk, reward, and correlation to the others. Putting the asset classes together to meet your goals is where the bulk of the heavy work should be done.

A 2007 Study Predictable Returns and Asset Allocation: Should a Skeptical Investor Time the Market? . by Jessica A. Wachter, Wharton School Of U. Penn, and Missaka Warusawitharana, of The Federal Reserve Bank, concludes that over the long term investors should resist the advice of those who take extreme positions about asset class allocation.

There are two schools of thought (dogmas) on asset allocation and market timing which are related.

1. Consistent successful market timing is impossible, and asset allocations should only be shifted when your life circumstances have changed.

2. You can predict the performance of an asset class and in the extreme it can pay to shift back and forth between all equities and all bonds.

They concluded that a middle ground approach worked best. i.e. be skeptical of the market timers’ claims, but be willing to modestly alter your asset allocation when the evidence in favor of doing so is particularly compelling In the following chart classes are listed in order of performance of their market indexes. You can see from the following chart that relative class performance varies widely over time.

(Performance includes dividends)

A Spread Sheet where you can experiment with different allocations and see results.

In trying various scenarios with the spread sheet above for 1992-2006 I found:

• Re-balancing each year got a 0.5-1% / year improvement over a buy and hold strategy.
• Selecting the initial mix had much more effect, with results varying from 11-14%. An equal mix of all seven asset classes rebalanced each year gave an average of 11% / year re-balanced return and and a 10.4% buy and hold return over 15 years.

A mix of 40% NASDAQ-100 and 60% S&P MidCap 400 gave a 14% re-balanced return and 12.9% buy and hold return.

The best mix with some bonds and international I could come up with was: