Like most of my clients, I grew up with preconceived ideas about investing firmly planted in my head. These ideas seemed so sensible that they were almost considered universal truths. Everyone I knew seemed to believe the same things. There didn’t seem much point in checking the facts, and anyone who disputed our inspired beliefs was most likely a few bricks short of a full load.

In general terms, our basic understanding was as follows:


  • Knowing which stocks to buy and when to be in the market is the key to investment success.
  • A good investor can predict which way the market is going and which stocks will profit the most. This power is held by just a few wise men. These wise men will readily share their power with you for a nominal cost. This minor cost will be repaid many times over by enhanced performance. However, one must always avoid the charlatans who give false advice. A wise man is one whose stocks go up, and a charlatan is one whose stocks go down.
  • Knowing when the market will fall is a prime concern to the successful investor. One should leave the market when it is about to go down in order to preserve his principal.
  • Successful investors trade often, and dart in and out of the market or a particular stock with uncanny skill. Their portfolios benefit from a hands-on approach.
  • It is rather easy to spot good companies through an examination of financial data, and to determine what the stock in those companies should be worth.
  • An astute investor can apply superior insight to make big killings on mispriced stocks. Using his superior insight he will be able to take action long before other investors catch on.
  • Studying past price movements is an aid to predicting future price movements. This skill can be applied to both individual stocks and the movement of the market as a whole.
  • Economic predictions are reliable, and form another strong foundation for success.
  • It is reasonably easy to select good advisors and managers, because their past track record is a reliable indicator of future success and skill.

Given all that, we tended to think of the investment process in the following terms:


  • What stocks should I buy?
  • Should I be in or out of the market now?
  • When should I sell my stocks?
  • Which manager should I hire? Or, what mutual fund should I buy?

Unfortunately, almost all of this conventional wisdom was dead wrong! It doesn’t do us any good to think of investing in these terms. In fact, it creates problems, and keeps us from enjoying the fruits of a game strongly tilted in our favor.

From personal experience, I can tell you that it is very difficult to unlearn something you have always known. We tend to cling to those old familiar ways of thinking in most unreasonable ways. Change is difficult and painful. We resist it. We rationalize. We fight for the old ideas every step of the way. We practically have to be hit over the head with a better idea before we will consider it. We want to ignore the idea and discredit the person who calls it to our attention. Most of us are not as flexible or rational as we would like to think we are.

In this chapter, we will consider the merits of the investor’s obsession with individual stock selection and market timing. Just how much do these two elements of the investment process contribute to overall success or failure? Is there a better way to think about investing?

A Ground Breaking Study

In a landmark study, “Determinants of Portfolio Performance,” published in the Financial Analysts Journal (July-August 1986), Gary P. Brinson, L. Randolph Hood, and Gilbert Beebower examined the investment results of 91 very large pension funds to determine how and why their results differed. The pension funds, which ranged in size from $100 million to well over $3 billion, were studied for the 10-year period ending 1983. Very complete and extensive data was made available on each of the funds from the SEI performance database.

Even the smallest of these pension funds represented a very large investment pool. We can assume that they commanded the very best talent available. Each was the valued client of one or more of the largest and most prestigious investment managers in the world. As such, they automatically received the best research and information. In other words, they certainly had the resources available to “beat the market.”

The team did a very simple but powerful and elegant analysis. They reasoned that only four elements could contribute to investment results: investment policy, individual security selection, market timing, and costs. By using a rather straightforward regression analysis, they were able to attribute the contribution (or lack of it) to each of the four elements.

Investment policy was defined as the average base commitment to three asset classes: stocks, bonds, and cash. For instance, a pension fund might have a mix of 60 percent stocks, 30 percent bonds, and 10 percent cash. (Most investment advisors use the term asset allocation rather than investment policy.)

Market timing was then determined by variations around the base commitments. If a pension fund changed its commitment to the three asset classes over time, it was assumed to be an attempt to profit from market timing.

The conclusions were remarkable. Using market-index returns for the three asset classes, (S&P 500 for stocks, Shearson Lehman Government/Corporate Bond Index for bonds, and the 30-day Treasury Bill for cash) the team was able to explain 93.6 percent of a pension fund’s performance based solely on knowing its investment policy! The biggest single factor explaining performance was simply the investment policy (asset allocation) decision that determined how much a fund should hold in stocks, bonds, or cash.

Asset Allocation

That left less than 6 percent of the difference in results to all other causes! The other factors contributed to the differences in total return, but not necessarily in a positive way. Attempts at market timing almost always resulted in a reduction of return, and individual stock selection on average resulted in a reduction to the funds’ returns. There was a wider variation in individual stock selection impact than in market timing, and a few managers were able to affect performance during the time period in a positive manner. Cost and execution differences for these very large investment plans were not an important factor (but you can believe they are a very important factor for you!).

Continuing the analysis, the study concluded that on average, attempts to actively manage the portfolios actually cost the average fund 1.10 percent per year when compared to just buying and holding the appropriate indexes. The best and the brightest that Wall Street could offer couldn’t reliably deliver.

Wall Street Cries Foul

The study touched off a major war within the industry, and between Wall Street and academics. After all, Wall Street’s entire business is built on the belief that brokers and analysts can contribute value to the investment process with their insight into individual security selection and market timing. Each brokerage house or investment manager wants the public to believe that somewhere in the back office is a genius who can make you rich. Our research/contacts/methods/insights/forecasts/gurus, they say, are better/smarter/more effective than what the other guys can offer!

As the study was further disseminated, cries of anguish and pain resounded across the land. What if investors suddenly got the idea that Wall Street’s highly praised research was garbage, that massive active trading didn’t add value, and that a broker’s advice was worth less than zero? What would happen to fees and commissions? The idea was simply unthinkable! Huge fortunes and giant egos were on the line.

When faced with a study you don’t like, one of the first lines of defense is to attack the data. If the data is published for all to see, and indisputable, all is still not lost. You can always claim that the other side “mined the data.” (These are serious fighting words in academia!) Mining the data means that the entire study is flawed because the data is so limited that the results can not be projected to other areas. In other words, the conclusion only applies in this one little, obscure, and unimportant case. Your study is garbage, and although interesting and amusing in an academic sense, at the very best you have produced trivia! Left unspoken is the implication that you have a tiny mind and perhaps foul motives.

If you are ever accused of mining the data, your first defense is to go find another set of data and get similar results. The more different sets of data that you can find with similar results, the stronger your claim. So, the authors redid the study, and generated almost identical results.

Today, this issue is considered reasonably settled. No one with an IQ higher than room temperature disputes the impact of asset allocation on investment results. Large institutions and sophisticated investors are increasingly turning to asset-class investing. What’s more, similar studies have repeatedly contributed to the diversion of assets away from active management and into passive or index funds. In fact, between 1970 (the year such funds were introduced) and 1990, over $500 billion has moved into these funds. The trend is continuing to accelerate as a growing number of investors realize the advantages: more reliable performance, lower cost, and lower risk.

Asset Allocation: The Lessons for Investors

Is there a lesson here for us? If the vast majority of investment returns can be attributed to an asset allocation decision, shouldn’t we concentrate our efforts where they will have the most impact?

It is far more rational to decide first how much risk we are willing to bear, and then decide which markets we wish to enter and which we wish to avoid. Next, we must decide what proportion of our assets to put in each selected market in order to meet goals within our risk tolerance. In terms of ultimate results, these are by far the most important decisions we will have to make. The impact of asset allocation or investment policy outpaces all other decisions.

Having come this far, we are free to consider whether it makes sense to attempt to actively manage a portfolio, use index funds, or mix the two techniques. In terms of the impact we can expect, these choices may reflect fairly important details or perhaps individual preference.

Today, the asset-class decision is more complex than just a decision on stocks, bonds, or cash. Literally hundreds of separate and distinct asset classes could be identified, and more are constantly being proposed. Each has different combinations of risk, reward, and correlation to the others. Putting the asset classes together to meet your goals is where the bulk of the heavy work should be done.

Asset-class investing – that is, investing and making commitments to whole markets rather than individual securities – is a fundamental shift in emphasis from what most of us grew up with. Rather than ponder over whether to purchase GM or Ford, we should be deciding how much of our assets to commit to U.S. large company stocks. Rather than wondering whether to buy now or later, we should be thinking in terms of long-term commitments to our chosen asset classes.

In turn, these new insights open up a whole new can of worms to deal with. What role should investment managers play? Can managers add value to the process? Are they worth their cost? Can they beat the market?

In the next chapter, we will cover some of the debate on efficient markets. If you believe markets are efficient, then the traditional stock-picking, market-timing managers who claim they add value have a tough case to prove.