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Economics and Portfolio Strategy

PeterL. Bemstein, Inc. 575 Madison Avenue, Suite 1006 New York, N.Y. 10022
Phone: 212-421-8385
FAX: 212-421-8537

January 15,2002
ASSET ALLOCATION VERSUS SECURITY SELECTON:
WfflCH MATTERS MORE?
By Mark Kritzman
It is not often one produces a study that is unambiguous, incontrovertible, and best of ali
diametrically contrary to received doctrine, but what follows is just such a study.1
i

One of th most debated issues of investment management is th relative importance of asset

allocation and security selection - not which activity is more important but rather how much more
important is asset allocation than security selection. Contrary to th universally held view, it tums out
that choosing stocks within th equity component of a portfolio is substantially more important than
choosing a portfolio's exposure among stocks, bonds, and cash. Ecfore I demonstrate th dominant
importance of security selection, let's review th research that gave rise to th conventional view that
asset allocation is th more important investment activity.
The Received Doctrine
Por as long as I can remember, th prevailing wisdom among professional investors has been
that individuai stocks are highly correlated with one another; thus it doesn't much matter which stocks
one owns but rather th exJtaiUpjgihiclLPjiejawns stocks. In 1986 Brinson, Hood, and Beebower
provided Tnpincirsap^rToTthis view with th publication of "Determinants of Portfolio
Performance."2 In this classic study, th authors attributed th performance of 91 large corporate
pension plans to three investment activities: policy, timing, and security selection. They computed th
policy return as th long-term asset mix invested in passive asset class benchmarks. They then
measured th incrementai effect of timing as th return associated with deviations from th policy mix
assuming investment in passive benchmarks. And similarly they measured th incrementai effect of
security selection as th return associated with deviations from th passive benchmarks within each
asset class. Their analysis revealed that th choice of asset allocation policy, on average, accounted
for 93.6% of total return variation through tme and in no case less than 75.5%. Brinson, Singer, and
Beebower updated this study in 1991 and found that policy stili accounted for more than 90% of
return variation.3

unless, of course, l'm wrong.

Brinson, G.P., L. R. Hood, and G.L. Beebower, "Determinants of Portfolio Performance," Financial Analysts
Journal, July-August 1986.
:
3 Brinson, G.P., B.D. Singer, and G.L. Beebower, "Determinants of Portfolio Performance II: An Update,"
Financial Analysts Journal, May-June 1991.
1

Ibbotson and Kaplan weighed in on th debate last year with an analysis that distinguished
cross sectional return variation from intertemporal retum variation.4 They confirmed th Brinson et al
result that asset mix policy accounts for more than 90% of return variation through lime, but they
demonstrated that only 40% of return differences across funds is attributable tp asset mix policy.
There is nothing wrong with either of these studies. They provide correct answers to th
questions posed by their authors, which dealt with decomposition of historical performance.
Nevertheless, many interpreters of this research seem to overlook th manner in which historical
performance depends on two separate influences: 1) investment opportunities available from variation
in asset class and security retums, and 2) th extent to which investors chose to exercise discretion in
exploiting these opportunities. These studies arejherefore_ajoint test of investor behavior and capitai
do not answer th queston, wHdTaciEviryTrn^^
allocation or security selection. To answer this question, we need to perform an experiment that
isolates th opportunity to affect wealth5 by engaging in asset allocation or security selection from th
confounding influence of investor behavior.
Resolution by Bootstrapping
After working many years in th investment industry, I have come to th realization there are
only two types of investors: those who are talented and those who are unlucky, so I will couch my
discussion around these two types of investors. A talented investor benefits more by engaging in
actvities that produce greater variation in wealth, while an unlucky investor benefits more by
avoiding actvities that cause greater variation in wealth. Therefore, th relative importance of asset
allocation and security selection depends dispositively on which activity has th greater potential to
cause variation in wealth, regardless of whether one is talented or unlucky.
By employing a simple but powerful technique called bootstrapping I show thatjtock
selection has th potential to impact wealth much more than a"sset allocation. Bootstrapping is a
"procedure by wmchnew samples are generated from an originai data set by randomly selecting
observations from th originai data set. It differs from Monte Carlo simulation in that it draws /J
randomly from an empirical sample, whereas Monte Carlo simulation draws randomly from a
theoretical distribution.
My data set includes th stock retums of each of th five hundred stocks in th S&P 500 index
as it was constituted at th beginning of 2001 as well as th returns of th J.P. Morgan government
bond index and th J.P. Morgan cash index.6 I use calendar year returns beginning in 1987 through
2000, and I also include year-to-date returns for 2001 through November 21".
The stock selection bootstrap proceeds as follows for each of th 15 years.
1 . Randomly select a stock from th S&P sample and calcolate its total return.
2. Replace th randomly selected stock into th originai sample.

4 Ibbotson, R.G., and P.D. Kaplan, "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of
Performance?" Financial Analysts Journal, January/Febmary 2000.
5 Purists may quibble that expected utility is what matters. I do not wish to complicate th analysis, and
moreover, my essential message would not change if I used expected utility as my numeraire.
6 1 do not have individuai stock data for th S&P 500 index as it was constituted each year. Therefore, my
sample suffers from attrition as I calcolate returns for earlier years. For example, in 1997 my sample included
473 of today's S&P stocks, and in 1987 my sample included 379 stocks.


3. Again randomly select a stock from th S&P sample, calcolate its total return, and replace
it.
4. Continue to select stocks randomly with replacement until 100 stocks are chosen.
5. Calculate th average total return of th 100 selected stocks.
6. Repeat steps 1 through 5 1,000 times.

This bootstrapping procedure produces annul returns over 15 years for 1,000 randomly
selected stock portfolios. I constrain these portfolios only in that I disallow short positions. The
replacement rule allows stocks to be selected more than once; thus th individuai security weights can
range from 1% to 100%. Moreover, th portfolios' exposures to factors, sectors, and industries are
determined randomly. The bootstrapping procedure pays no attention to benchmarks or risk exposure.
It is th purest form of random security selection.
The asset allocation bootstrap proceeds similarly for each of th 15 years.
1. Randomly select th equally weighted S&P stock index, th J.P. Morgan
govemment bond index, or th JPM cash index and calculate its total return.
2. Replace th randomly selected asset into th originai sample.
3. Again randomly select th equally weighted S&P stock index, th JPM govemment bond
index, or th J.P. Morgan cash index, calculate its total return, and replace it.
4. Continue to select assets randomly with replacement until 100 assets are chosen.
5. Calculate th average total retum of th 100 selected assets.
6. Repeat steps 1 through 5 1,000 times.
This bootstrapping procedure produces annul returns over 15 years for 1,000 randomly
selected asset portfolios in which th component securities are fixed. Because there are only three
assets from which to choose (stocks, bonds, and cash), each asset is likely to be selected more than
once. For example, if th stock index is selected 25 times, th bond index 40 times, and th cash
index 35 times, th bootstrap produces a random asset allocatici! of 25% stocks, 40% bonds, and 35%
cash. Moreover, because th component securities of each of th assets are fixed, th return variation
among th 1,000 portfolios arises purely from random variation of th asset mix.
What could be simpler? I measure th importance of security selection by holding Constant
asset mix and calculating variation in wealth due to random security selection. Then I measure th
importance of asset allocation by holding Constant security weights and calculating variation in wealth
due to random asset allocation. And th answer is...?
The Answer
Random selection of securities within th equity component of a portfolio causes substantially
more return variation than does random asset allocation among stocks, bonds, and cash. Figure 1
shows th extent to which a top quartile (talented) investor would improve average performance
dependmg on whether she engaged in stock selection or asset allocation. It also shows how much
worse than average a bottoni quartile (unlucky) investor would perform depending on th dioice of
investment discretion.

4
Figurai
25th and 7Sth Percentle Performance Each and Every Year
Annualiz.d Drfference from Awrtge (1987-2001 )

80%
stocks

100%

stocks

60%
stocks

Asse!
Allocai ton

40%
stocks

Moving from left to right, I assume security selection is applied to smaller fractions of th
total portfolio. The left bar assumes 100% of th portfolio is allocated to stocks and th individuai
stocks are selected randomly. The next bar to th right assumes 80% of th total portfolio is allocated
to random stock selection, with th balance divided equally between bonds and cash. The bar furthest
to th right assumes th total portfolio is allocated randomly among stocks, bonds, and cash, with th
stock portion equally weighted among th component securities. Even with only 20% of th portfolio
allocated to stocks, security selection is stili th dominant investment activity.
Figures 2 shows th same comparison for a really talented investor (5* percentile) and a really
unlucky investor (95* percentile).
Figure 2
5th and 95th Percentile Performance Each and Every Year
Anmuiltud Kfference from Awr.ge (19(7-2001)

10.00%

5.00%
0.00%
-5.00%
-10.00%
100%

stocks

80%
stocks

60%
stocks

40%
stocks

20%
stocks

Asset
Allocation

Figure 3 repeats th comparison for a really, really talented investor and a really, really
unlucky investor (I51 and 99* percentiles, respectively).

Figure 3
1 stand 99th Percentile Performance Every Year
Annualizod Diffonde* from Avtrag* (1987-2001 )

15.00%
10.00%

5.00%
0.00%
-5.00%
-10.00%
-15.00%
100%

stocks

80%
stocks

60%
stocks

40%
stocks

20%
stocks

Asset
Allocation

You may argue that my defmitions of a talented investor and an unlucky investor are
unrealistic because they require th investor to perform in th respective percentile each and every
year over th entire 15-year horizon. Figures 4, 5, and 6 address this concer by defning talented and
unlucky according to th cumulative percentile ranking at th conclusion of th 15-year horizon,
assuming annual rebalancing along th way. Althpugh th deviations frorn average performance are
smaller, th relative importance of asset allocation and security selection remains unchanged.
Security selection has much greater potential to affect wealth than does asset allocation, even if
security selection is applied to less than 20% of th total portfolio.
Figure 4
25th and 75th Percentile Performance Over Horizon
Annui lized Differente frotn Average (1917-2001)

80%
stocks

60%
stocks

40%
stocks

20%
stocks

Asset
Allocation

Figure 5 .
5th and 95th Percentile Performance Over Horizon
Annualized Difference from Average (1987-2001)

60%
stocks

100%
stocks

40%
stocks

20%
stocks

Asset
Allocation

Figure 6
1 stand 99th Percentile Perrormance Over Horizon
Annualteed Difference from Average (1987-2001)

5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
-1.00%
-Z00%
-3.00%
-4.00%
80%
stocks

60%
stocks

40%
stocks

20%
stocks

Asset
Allocation

Objections
How might you object to my analysis?

/ only allow security selection within th stock component.

' '>' Trae, but greater discretion to vary security exposure within bohds and cash would only > ; : : :'.:
amplify th dominant influence of security selection.

/ limit my stock universe to th S&P 500, and in earlyyears attrition reduces my universe
evenfurther.
True, but a larger universe would enhance th opportunity to affect wealth by security
selection.

Investors are not willing to deviate signifcantly from equity benchmark weights.
True, but most are not willing to deviate signifcantly from a 60% stock exposure. Moreover,
th relevant issue is not what behavior provides comfort to investors, but what opportunities
are available by engaging either in asset allocation or security selection.

Because I only include stocks that have survivedfrom 1987 to 2001 my stock sample is
biased.
My sample may or may not be biased. Moreover, to th extent th performance of th deleted
stocks has been greater or worse than th surviving stocks, my experiment understates th
potential impaci of security selection on wealth.

My choice of an equally weighted index biases th result against asset allocation.

This would only be true ifa capitalization weighted index weremore variable than an equally
weighted index, which is doubtful given th higher variability ofsmaller stocks.

My study focuses only on wealth and ignores risk.

False. My study is ali about risk. I measure th effect of asset allocation and security
selection on th dispersion of wealth. Por talented investors dispersion is an opportunity toj
be exploited. Por unlucky investors, dispersion is a risk to be avoided. Dispersion defines /
risk.

Security selection has much greater potential to affect wealth than does asset allocation.
Investors have concluded falsely that asset allocation is more important, because performance
attribution studies confound investment opportunities with investor behavior. The dominance of asset
allocation in explaining past performance only reflects th industry's unwillingness to engag
meaningfully in security selection. Given th resources to acquire skill as an asset allocator or a stock
picker, there is no doubt about which skill is better to acquire. And given th ability to avoid bad luck
as an asset allocator or as a stock picker, there is no doubt about which type of bad luck is better to
avoid.
oOo
"Economics & Portfolio Strategy" is copyrighted 2002 by Peter L. Bernstein, Inc. Factual material is not
guaranteed but is obtained from sources believed to be reliable. No part of this publicaton may be reproduced
in any fonn without written pennission. .
.
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