74 The CFA Digest

August 2003
2003, AIMR

Asset Allocation versus Security Selection:

Evidence from Global Markets
Mark Kritzman, CFA, and Sbastien Page
Journal of Asset Management
vol. 3, no. 3 (December 2002):202212
The authors challenge the widely held belief that the asset
allocation decision is more important than the security selec-
tion decision. They believe that investors have misinterpreted
the results of prior studies and show that choosing stocks within
the equity component of the portfolio is substantially more
valuable than choosing a portfolios exposure among stocks,
bonds, and cash.
The authors review the current literature supporting the widely held
view that asset allocation is more important than security selection.
They find nothing inherently wrong with the studies that have been
done but nevertheless conclude that a mathematical model of relative
importance, rather than a decomposition of historical performance,
is necessary to assess the relative value of asset allocation versus security
selection.
The authors define importance as the extent to which a particular
investment activity causes a dispersion in wealth. This metric matters
to investors who believe they possess, or can acquire, the skill needed
to exploit this volatility and increase wealth by going beyond a passive
indexing strategy.
To simulate real-world conditions, the authors use bootstrapping and
a dataset that includes individual stock returns. Their simulation
procedure produces cumulative returns over 14 years for 1,000 port-
folios whose stock allocation is fixed at 60 percent; individual stocks
are selected randomly each year. The importance of security selection
is measured by holding the asset mix constant at a 60/30/10 allocation
among stocks, bonds, and cash, and then calculating the variation in
return caused purely by the variation among randomly diversified
Mark Kritzman, CFA, is at Windham Capital Management Boston and State Street
Associates. Sbastien Page is at State Street Associates. The summary was
prepared by Frederick J. Cornelius, CFA, Burt Associates, Inc.
Portfolio Management 75
aimrpubs.org
stock portfolios. The authors conduct a second simulation to isolate
the importance of asset allocation by randomly selecting different
asset allocations and holding the security selection constant.
The results show that random variation among individual securities
within the stock component of a portfolio causes substantially more
return variation than random asset allocation among stocks, bonds,
and cash. The authors rank the portfolios by utility, which compen-
sates for both return and risk, rather than simply by annualized return.
This utility-ranking procedure further confirms the conclusion that
security selection is more important than asset allocation.
To quantify the value of asset allocation skill and security selection
skill, the authors use a variation of the BlackScholes option pricing
model. They find that the value of an exchange option for top-quartile
security selection performance exceeds that of an exchange option for
top-quartile asset allocation performance by a factor of four. This
trend is apparent not only in the United States but also in all the
countries studied. This finding reinforces their earlier results about
the relative importance of security selection.
The authors believe that many investors have falsely concluded that
asset allocation is more important than security selection because past
studies have successfully attributed historical performance to the asset
allocation decision. These studies, however, failed to distinguish
between investor behavior and capital market opportunities. Thus,
the authors assert, the correct methodology must control for investor
behavior in order to isolate the relative importance of the asset
allocation versus the security selection decision. In addition, they
maintain that the dominance of asset allocation in explaining past
performance merely reflects the industrys unwillingness to engage in
meaningful security selection.
Keywords: Portfolio Management: asset allocation