Smart Investor : Asset Allocation

Asset allocation is the process of strategically spreading your money across a variety of asset classes and investment styles. Just how important is asset allocation?
Instinctively, you may think that the individual securities you own drive investment performance. But according to one prominent study, asset allocation was singled out as the largest determinant of a portfolio’s success.

Modern Portfolio Theory
Asset allocation is just one component of Modern Portfolio Theory, which was introduced in 1952 by Nobel Prize winning economist Harry Markowitz. In summary, Modern Portfolio Theory suggests that the risk of a particular security should not be looked at on its own, but rather in relation to a portfolio as a whole. It also explains how risk-adverse investors can construct a portfolio that optimizes expected returns given a particular level of market risk.

The study analyzed data from 82 large corporate pension plans with assets of at least $100 million over a 10-year period beginning in 1977 and concluded that asset allocation policy explained on average 91.5% of variation in total plan return.