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Modern Portfolio Theory and Brinson's Asset Allocation came into being when the "boyz 'n the 'hood" at your local institutions of higher learning did a little back testing of the past performance of investment sectors. 

They added the investment term "Asset Allocation" to be on a level with their credentials/studies/writings and then, oh yes, produced pounds and pounds of equations. 

They came to the profound conclusion about asset allocation that, in part, is obvious to begin with:

• "Data from 91 large US pension plans indicate that investment policy dominates investment strategy (market timing and security selection), explaining on average 93.6% of the variation in total plan return ." Brinson et al. 1986.

Brinson et al. describe the investment process used to manage a portfolio as a hierarchy of three decisions taken one after the other:

• Investment Policy
  • Decision 1: Choice of asset classes in which to invest.
    
    
  • Decision 2: Choice of normal asset class weights that remain unchanged over time.
    • The weights are often determined by an optimization procedure designed to generate an expected risk (variance) and return appropriate to the circumstances of the particular investor. (Choice of asset mix.)
      
      
• Investment Strategy
  

• Decision 3: Security selection and market timing.
  • Choice of individual securities within each asset class, and adjusting the asset class weights from their normal values on a short-term basis.

The conclusion: "The contribution of investment policy is the overwhelmingly dominant contributor to total return, and dwarfs the contribution of investment strategy."

Hmmmmm, let me see if I understand.......

Invest in the right asset classes and the right investment sectors with the right mix and with the right amount of investment capital and investors will do better than if they invest in the wrong asset classes and the wrong investment sectors with the wrong mix and with the wrong amount of investment capital? 

What a concept!

It was further concluded that the selection of individual investments and investment timing, an "investment strategy," had little to do with investment performance. 

Hmmmmm, let me see if I understand.......

Whether you select the right investment at the wrong time, the wrong investment at the wrong time, the right investment at the right time, or the wrong investment at the right time, your decision will have little to do with determining investment performance?

They received a Nobel Prize for this?

Felony stupid!

Gary Brinson and associates studied a group of pension fund managers and used their results to generalize about investing, investment performance, investors, and investment advisors.

They limited the scope and the breadth of their study to a group of pension fund managers and, therefore, limited the possible conclusions down to one:

• They concluded, you will never guess what they concluded, that over 80% of the differences in performance, "the variations in total returns," among investment professionals could be explained simply by classifying and ranking the pension fund managers, used in their very "limited and selected study," according to how much of their assets were placed in three broad asset classes; stocks, bonds, and cash.
  • The best mix of the three asset classes had the best results.
• Do you mean to tell me that the top money manager could pick the best mix of the three broad assets classes by ranking their performances correctly and by weighting the capital to be applied to each of the broad asset classes correctly based on their projected performance rankings and then could choose a broad range of the worst underlying investments at the worst time for each broad asset class and that that money manager would have the best investing and investment performance results?

Worst of all, the conclusions of Brinson's Asset Allocation Study are being misused daily by the new and naïve minions of Brinson Asset Allocation believers who, by misquoting Brinson by omitting the words, "the variation in," in the phrase, "explaining on average 93.6% of the variation in total plan return...," have been able to further compromise the initial Brinson Study and its general conclusion to create a more specific and vastly more convenient, though completely untrue, Brinson's Asset Allocation conclusion such as, "explaining on average 93.6% of total plan returns" to conclude that asset allocation (of asset classes) alone determines 93.6% of investment returns.

• Not correct, it is only the variations in, the differences of performances between the money managers used in the study that are explained by the study.
  • And, the actual Brinson conclusion is also absurd becasue they conclude that investment selection and investment timing are not factors in the investment performance equation.

Other poorly translated, and incorrect, conclusions of Brinson's Asset Allocation theory include the following:

• "The results of this study have had an overwhelming impact on the way investment portfolios are constructed, managed, and compared."
•  "You would have beaten over 80% of all professional money managers if, over the past ten and twenty years, you held one quarter each of indexes of large US stocks, small US stocks, foreign stocks and high quality US bonds."
•  "The amazing truth is that over a long enough time period almost any reasonably balanced index strategy will best the overwhelming majority of 'professional' managers."

Well, without getting into the arguments of the validity of Brinson's Asset Allocation theory, no, let's get into it.

Because of the fiduciary capacity of pension fund managers to meet their investing responsibilities, this class of money managers did what most money managers under the same investing conditions would have done, they were more conservative and more on the investing defensive; don't need anybody going off on his or her own investing tangent trying to be a hero.

They used their best investing judgment to rank the future performance possibilities of the three investment classes.

They allocated capital accordingly.

They diversified into many different investments within each of the broad asset classes. 

As there was very broad investment diversification within asset classes so as not to be too aggressive with very conservative capital, stock selection, the art, the expertise, the skill of picking the best, the most timely investments within broad asset classes, would have to be diminished in importance as the number of investments in each investment sector within each broad asset class were increased.

The more the diversification to reduce investment risk, the closer to investing in all of the investments in an asset class, the closer to index investing, the less "stock picking and investment timing" there can be and the less important stock selection and market timing, therefore, will be. 

Since the investment styles essentially had to be/were the same, and the broad selection of investments within asset classes were similar, the only way to grade performance would be to see who did the best in picking the distribution of capital to the three asset classes. 

The conclusions of Brinson's Asset Allocation would have to be that 80% (why not 100%) of the variation in plan performance was explained by how much capital was invested in the asset classes and that investment performance has little to do with stock selection and investment timing because the structure of Brinson's Asset Allocation left out all of the other investment variables that do affect investment results! 

If a broader universe of investment managers, investors, and investment styles had been used, the conclusions would have been that there are many factors that explain both variations in total investment returns and actual investment performance.

Granted, stock picking, investment timing pension fund managers used in the study may not have done well (a possible reflection of the skill levels of the fund managers or the difficulty of stock picking and investment timing) but that does not remotely translate into the conclusion that stock selection and investment timing have little impact on investment performance and into the suggestion that future investors need not place too much emphasis on investment selection and investment timing to improve investment performance.

The theory of Brinson's Asset Allocation is further flawed: 

• The samples used in the study were limited to but one class of investment advisor; pension fund managers.
• Choice of normal (whatever 'normal' means?) asset class weights remain unchanged over time.
• "The weights are often determined by an optimization procedure."
  • Optimization uses investment history; therefore, it is worthless for the investment future.
• Different investment styles for different types of investors with different investment goals, different investment risk tolerances, different investment time horizons, and different investment performance results were excluded from the study. 
• As for the lowly stock pickers and market timers, "Stock pickers and market timers were not the leaders with regard to investment performance."
  • They could not possibly be the leaders based on the terms and conditions of the study!
  • The small group of pension fund managers that emphasized stock picking and market timing, poorly represented, never had a chance.
• The "how much" of the... "best mix of the three asset classes" as selected and weighted by the best money managers was "determined by who used the best timing to select the best mix of the three asset classes, the very same factors that would be used by those selecting and timing investments."
  • Timing for asset classes and no timing for those selecting investments?
    • Timing, I thought that was out?

Any statement that reaches a conclusion that investment selection and investment timing have little effect on investment performance is ludicrous.

The theory of Brinson's Asset Allocation is absurd: 

• Think about this, the theory of Brinson's Asset Allocation states that investment selection and the timing of buying those investments has little to do with investment results.

  • All investing is about picking, selecting, timing, and weighting of asset classes, investment sectors, investment categories, and individual investments.
  • The one who has the best mix of all will always do the best.
• Allocate, but what you invest in to allocate is not all that important?

  • That conclusion is truly absurd.
    • Why not go to corporations that are looking for acquisitions and advise them not to pay too much attention to investment selection and investment timing.
    • Just allocate into broad asset classes and give no consideration to the selection and timing of the underlying investments in each broad asset class!
  • Try telling the guy who held onto his General Motors from 2002 to 2006 that instead of selling General Motors and investing in Boeing in 2002 that investment selection has little to do with investment performance. 
    • General Motors went generally southward from $70.00 in 2002 and to $20.00 in 2006....(to $3.00 in 2008.)
    • Boeing went generally northward from $30.00 in 2002 to $75.00 in 2006.
  • Try telling this same General Motors guy that he need not be concerned with investment timing.
    • With some investing skill, a little investment luck, and without much added investment risk, he could have owned over three times as many shares of General Motors with the same amount of initial capital had he sold GM in 2002, waited a few years, and then bought GM back in 2006...(and hopefully sold in 2007.)
  • Try telling Mr. GM that if he went a step further and had been lucky enough, smart enough to sell some or all of his GM in 2002 and purchased Boeing in 2002 that neither investment selection nor investment timing have much to do with investment performance. 
  • I know, I know, I know! The examples are the extreme and the rare exceptions of investment selection and timing perfection, but the conclusion is not; investment selection and timing are very important and they both are part of the investment performance equation.

Though the allocation of capital is an important starting point for designing and constructing investment portfolios, Brinson's Asset Allocation is a mindless comfort zone for those who are satisfied with being average and who do not choose to accept either the challenge or the responsibility of knowing how to select investments or time investing.

Enough of Brinson's Asset Allocation Theory Bashing!

Rather than assign an excessive valuation percentage to any one contributor of investment performance, 100% of investment performance can be explained by the proper heed and use of all of the following portfolio management considerations listed below.

The contributors to investment performance are listed in no particular order of importance, that is, until the final four; with grave reservation, they are most reluctantly included. 

They were included so as not to be guilty of doing what the fathers of the theory of Brinson's Asset Allocation did to manufacture their investment conclusions by arbitrarily omitting  some of the known variables that are also "overwhelmingly dominant contributors to total investment returns." 

.
100% of the lack of investment performance can be explained by ignoring these portfolio management considerations, by reversing their order, and/or by overemphasizing one at the exclusion of the others. 

I would have been happier and supported Brinson's Asset Allocation Theory with a burst of unbridled enthusiasm had it concluded that Modern Portfolio Theory, Efficient Frontier, Beta & Alpha, Monte Carlo, and Past Performance are the overwhelmingly dominant non-contributors that do not impact total investment returns and, in fact, these concepts had no value in accounting for 91.5% of total returns.

Visit: THE IMPORTANCE OF ASSET ALLOCATION by John Nuttall (for a more scholarly presentation)