Thursday, December 14, 2006

Determinants of Portfolio Return

I was playing around with this calculator ( and noticed that the constant annual growth rate of the stock market from 1950 through 2005 was about seven and a half percent. If you add in dividends, the total return of the stock market over that period worked out to about 11% or so. This kicks the pants off of the returns you can expect from investments such as money market accounts, or even bonds for that matter.

So why would a young person like me (28 years old and probably 40 years away from retirement) put their retirement money into anything besides stocks? Some people argue that you can improve your overall returns and lower your risk if you put 10-20% of your retirement funds in bonds. My bond allocation is much lower - more like 5%. This is mainly because I am so young and I am not a very risk-averse investor. I believe that the stock market will continue to outperform bonds and cash over the long run, so I am willing to put more of my retirement savings into stocks.

There was a famous study published in 1986 called "Determinants of Portfolio Performance" by Brinson, Hood, and Beebower. They concluded from a study of a bunch of portfolios and how they performed over time, that over 90% of a portfolio's long term performance is explained by asset allocation, rather than stock selection. This means it is about nine times more important for you to decide what percentage of your portfolio you will allocate to stocks, bonds, and cash (t-bills) than for you to decide what specific investments in those categories to invest in.

So don't go crazy looking at a bunch of different mutual funds. If you're my age and 20% of your retirement money is in bonds, and 80% is in a few good mutual funds with low fees (such as index funds or ETFs), then you're on the right track. All of the fluff and advertising done by all of the mutual funds is generally nothing but smoke and mirrors. When you get down to it, investing can be an extremely simple task, once you've learned the basics. You don't even have to dip into a single balance sheet or income statement if you don't feel so inclined. Just invest in index funds and spend your time with your family, at your job, or unwinding with a good book.

No comments: