Asset Allocation Essay

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Dr. Anne Macy – Portfolio Theory 1 ASSET ALLOCATION The asset mix is responsible for over 90% of the returns to a portfolio in any given year. If you are in bonds and bonds have a good year, so will you. You might have a great year because you chose great bonds instead of mediocre bonds. But if you are in bonds and stocks have the good year, you won’t. It might be tempered somewhat if you hold bonds that do better than their averages. The morale is that the market ebbs and flows. A good market in an asset class takes all the instruments in that class up with it unless there is something strongly negative about your particular instrument. In 1999, technology stocks were king and healthcare did not do well. By 2001, the positions were reversed. In 2002, stocks underperformed bonds. Financial stocks did great during the housing boom but cratered during the housing bust and financial bust (naturally). While homebuilders and financials tanked, dollar stores did well. One academic study found that asset allocation accounted for 92% of long-term portfolio performance. Security selection accounted for 4% while market timing and other accounted for 2% each. The idea is not so much whether you invested in Abbott or Johnson & Johnson but whether you were in healthcare stocks or not. Does this mean that security selection is unimportant? Absolutely not. While asset allocation can explain over 90% of the total returns in a year, asset allocation explains about 40% of the variation of returns between portfolios. This means that if healthcare stocks had a great year and your portfolio was heavy into healthcare stocks, you probably also had a good year. However, when comparing your portfolio with another portfolio also heavily invested in healthcare stocks, the portfolio with the better stock selection will perform better. Yes, security selection is important but after asset

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