The True Determinants of Portfolio Returns Have Nothing to do with Asset Allocation

December 18, 2006 – Almost every single person that has ever been managed by a large global investment firm has seen the below chart. It’s called Determinants of Portfolio Performance, but I’ve renamed it Determinants of a Financial Consultant’s Asset Gathering Success, because such a title is far more accurate. Financial consultants tell you that studies too numerous to count have been performed that prove the above “facts”. My question is, Whom were the studies performed by? By people the firms hire? I’m not really sure who has performed these studies and I really don’t care because I know they’re wrong and that’s all I need to know. Just like tobacco firms hired doctors to tell us that cigarettes weren’t responsible for giving you lung cancer, investment firms will continue telling you certain things that are not true as well.

determinants-assets.gifIn the end it’s really up to you to decide whether or not to believe all the theories they propagate and mass disseminate. I’ve stopped believing almost all their theories a long time ago, and ever since then, my investment returns have tripled and quadrupled. In any event, financial consultants use the above chart to convince you that not much time is necessary to decide how your hard earned money is invested. They will never say that verbatim to your face, but in essence, that is what the above chart implies.

What’s wrong with the above pie chart, you might ask?

The pie chart that is used by so many financial consultants all over the world claims that only 4.6% of portfolio performance is attributable to stock picking, 1.8% is attributable to timing, 2.1% is attributable to other (I’m not sure what is in the “other” category, maybe planet alignment and sun flares), and that 91.5% of your portfolio returns are determined by asset class allocation only.

Isn’t it just a tad ironic that the overwhelming number of financial consultants at investment firms utilize money managers to invest your money and never select specific stocks for you while also claiming that only a measly 4.6% of your returns is attributable to actions they rarely engage in? If such a claim were true, then the commoditization of financial consultants would be possible. If it were true, then it wouldn’t make a bit of difference whether a green, straight-out-of-college 22 year-old kid, or a 55 year-old man with salt and pepper hair managed your $3 million. And to tell you the truth, because global investment firms have largely commoditized their financial consultants, providing all with the same access to the firm’s asset allocation recommendations and providing all with the same software to screen for external and internal money managers, your portfolio is not likely to see significant differences in returns between a green kid and one that’s been in the business for 20 years.

But it should.

You’re probably a lot less likely to hand your money over to a kid that’s green for the simple reason that you believe that he or she couldn’t manage your portfolio as well as someone more “seasoned”, but the fact is, with the commoditization of the financial consultant, it really is not going to make a large difference whom you choose. Global investment firms have built many of their strategies around the flawed investment theories that state 91.5% of portfolio returns are predicated upon asset allocation alone and only 4.6% are attributable to the specific stocks selected. They have convinced nearly the whole world that this is true, so spending time to select stocks that have great risk-reward setups for earning more than 25% or 30% a year is not necessary.

Let’s examine the assumptions of the above accepted determinants of portfolio returns. 91.5% to asset allocation, only 4.6% to specific stock selection, 1.8% to market timing, and only 2.1% to other factors. If you think about these statistics for more than five minutes, from a logical perspective, do they make any sense to you?

Do you really think that if you owned the five companies with the best management in the industry, that their share performance would be comparable to the five companies with the worst, bumbling, shortsighted management teams? If a business has forward sold contracts at the wrong time or if a business has not hedged against foreign currency exchange risk, this could be the difference between a profitable company and a losing one. Yet financial advisors always claim that it doesn’t really matter what individual stocks you own as long as you own the right asset classes. But what if technology is tanking in the United States but booming in India? And what if some countries in Asia are currently at more advanced stages of technology than other Western countries (which is true)? Is picking an Asian company most likely to benefit from this advanced stage of technology versus a Western one that can’t benefit at all truly irrelevant? (or near irrelevant, only responsible for 4.6% of returns?)

Performance in stock investing is 100% about investing in the right companies at the right time in the right countries. Period.

The only reason that the pie chart at the beginning of this section holds so much credibility in the investment world is because it has been cited so often without any significant dialogue regarding its deep flaws. As any war historian will tell you, tens, if not hundreds of millions of people believe erroneous “facts” about wars simply due to the fact that such “facts” have been taught in schools and repeated hundreds of thousands of times over many decades. Just because millions of people believe something does not make it true though global investment firms would like you to fall victim to this sheep-herd mentality (otherwise known as mob psychology).

I could tell you at least ten other things financial consultants from large global investment firms repeat over and over again that are just junk and severely harm your portfolio performance (you’ll find much more of this information inside the doors of https://www.maalamalama.com), but I think you get the idea by now. The below pie chart, almost a complete inverse of the above pie chart, I believe, much more accurately reflects the real “Determinants of Portfolio Performance”.

determinants-returns.gifThe lesson to take away from this is as follows: To build wealth through investing, seek someone that is a (1) a superior stock picker; (2) is very knowledgeable about global markets and is knowledgeable about regional trends; and (3) is knowledgeable about enough technical indicators to utilize market timing to your advantage. In many cases, the person best able to do this may just be you.


J.S. Kim is the founder and Managing Director of maalamalama, a comprehensive online investment course that uses novel, proprietary advanced wealth planning techniques and the long tail of investing to identify low-risk, high-reward investment opportunities that seek to yield 25% or greater annual returns.

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