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That Old-Time Religion


In 1986, three investment analysts named Gary Brinson, Randolph Hood, and Gilbert Beebower (BHB) published their landmark “Determinants of Investment Performance.”  It argued that 93.6% of differences in  the investment performance of various portfolios was due to asset allocation, i.e., the ratio of the portfolio allocated between stocks and bonds.  With 93.6% of the differences explained, a new religion was born.

Learned academicians wrote weighty papers on whether 70/30, for example, was better than 60/40.  (The latter refers a portfolio with a 60% allocation to stocks and a 40% allocation to bonds.)  Of course, a very young person might be 90/10 changing to 80/20 before becoming 70/30 and so forth.  This was the genesis of the “lifespan” mutual funds, which change the allocation between stocks & bonds for the participants as they age.   The mutual funds had a financial interest in keeping faith with BHB and protected it.  Arguments over the “magic” allocation became heated among the true believers.

In 2010, statisticians determined there were serious errors in the original BHB computations, having ignored fluctuations over the year.  At that point, the holy practice of asset allocation had already been practiced for 24 years and a whole sector of the mutual fund industry was built upon BHB.  Acknowledgement of the error was rare among investment advisors.  They continued to hang onto their old-time beliefs that the allocation between stocks and bonds was the primary determinant of investment performance.

This asset allocation theory never made sense to me, especially as a static allocation.  While BHB advocated rebalancing the portfolio assets, that point was missed by advocates of static allocation.  How could a static 70% allocation to stocks in 2007 be the same as a 70% allocation in 2021?  For one thing, the 30% allocation to bonds was safer in 2007 with relatively high interest rates than the 30% would be in 2021 with very low interest rates.  (Remember:  the value of bonds moves inversely to interest rates.)

Talking with a retiring attorney last week, he informed me that his portfolio should be 60/40.  He was certain that 60/40 was the magic ratio but had no idea why.  Somebody he respected must have told him that long ago . . .but I will be a patient teacher/advisor.

I am convinced that bonds are now dangerously overpriced, due to low interest rates.  The artificially-low interest rate environment since 2008 has killed BHB’s conclusion that 93.6% of differences in investment performance between portfolios is due to the allocation between stocks & bonds.  Maybe, that conclusion is simply suspended until we have a normal interest rate environment again and will return . . . but not today.

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