Contributions have the greatest effect on investors achieving their goals.
To say that the primary determinant of investment success is investing will strike many as either gratingly obvious or downright obtuse. Merriam- Webster defines the transitive verb form of investing as 1) to commit (money) in order to earn a financial return, 2) to make use of for future benefits or advantages. Or, with respect to what concerns us here: committing cash to a portfolio designed to grow and finance future consumption.
We live in a world dominated by the discourse of time-weighted returns. Asset managers live and die by their Sharpe ratios, trailing returns, and in some cases, Morningstar Rating. Investors, however, live and die by accumulated wealth. We now have a $71.4 trillion1industry dedicated almost solely to investment selection and asset allocation, with saving and withdrawal decisions often relegated to rules of thumb. The advent of robo-advisors and increased proliferation of software planning tools have begun to change this, but only slowly. The irony, as we shall see, is that savings substantially trump asset allocation when it comes to building wealth and reaching financial goals.
In this article, I show that investors and advisors would do well to put more emphasis on savings and withdrawal strategies than on investment selection and asset allocation. The long-reigning king of investment performance, asset allocation, takes a distant second in this larger goal-oriented race (although, to be fair, asset allocation catches up in importance as the race gets longer). I’ll show, too, that this saving-first approach to reaching financial goals affects how we invest.
Asset Allocation Crowned King
Much research has explored the impact of asset allocation and investment selection on performance. To be explicit, performance refers to the probability distribution of time-weighted periodic returns, or how wealth is generated as opposed to how muchwealth is generated.
The most famous—and in some quarters, infamous—paper that explored the relative drivers of performance was the widely cited and often wrongly interpreted “Determinants of Portfolio Performance” by Brinson, Hood, and Beebower (1986). One part of this paper showed that most of the variance of U.S. pension portfolios could be explained by the manager’s asset-allocation policy portfolio, a statement that interestingly says nothing about asset allocation’s impact on returns per se but rather that managers tended to stick closely to their benchmark.
The question of the relative importance of asset allocation to portfolio performance has been revisited periodically. Roger Ibbotson and Paul D. Kaplan clarified the issue in their paper “Does Asset Allocation Explain 40, 90, or 100 Percent of Performance?” (2000) by running separate analyses to determine the average variance of returns for the typical fund through time that could be explained by an estimated policy portfolio. They found that 40% of the variation among funds is explained by asset-allocation policy, and that (and this is the punchline) 100% of the return level (not variance) could be explained by asset allocation. Additionally, they showed that, for the most part, the primary driver of returns was “the market.” Simply being in the market is the most important factor—the policy portfolio, active asset allocation, and security selection are icing on the cake (or mud, depending on skill level and fees).
This research focused entirely on portfolio performance. In his 2010 piece, ”Asset Allocation Is King,” published in these pages, our colleague Tom Idzorek anointed asset allocation the leader, at least with respect to explaining investment return level. But when we widen our frame of reference, we can see that portfolio performance is only a part of the story. Sometimes, a very small part.
While comparatively little research of any depth has been written on how saving levels affect financial success, it hasn’t been ignored. In fact, a standard ordering of the investment process first ranks contributions—money saved into an investment account—then asset and product allocation, and finally investment selection. But the magnitude of contributions is particularly large. It’s rare that an investor can asset-allocate his or her way out of a funding hole. But hitting a financial goal with a portfolio later found to be suboptimal is not a stretch. In fact, this applies to virtually all investors over all periods.