Three scholars — Brinson, Hood, & Beebower — published a study in 1986 of 91 large pension funds’ investment performance from 1971-1983.  They consolidated individual investments into asset classes, i.e., stocks, bonds and cash.  They found that 93.6% of their investment performance resulted from their asset allocation, i.e., the percentage allocation to stocks, to bonds, and to cash.  Investment performance was not a function of wise investment in individual securities, like a particular stock or bond.  It was a function of asset allocation.  In 1991, they repeated that study again and found it was only 91.5% — very convincing indeed!

It was like daybreak in the investment world and passive investing or index investing was born.  The buzz words of “asset allocation” became sacrosanct.  That study quickly became the “conventional wisdom” among many investors, which is unfortunate, because it made the fatal assumption that bonds were a safe investment.

Importantly, that study was conducted in a normal interest rate environment, unlike today’s super-low interest rate environment.  When interest rates rise, the market value of bonds fall.  So, what happens to the 60/40 investor whose 40% is invested in AAA-rated long-term Treasury bonds?  Answer:  He gets crushed.

The problem is magnified for the income investor, who needs to maximize income from the portfolio.  In a normal interest rate environment, he would increase his allocation to bonds, because that is where the income should be.  Unfortunately, that is not true in this environment..

Likewise, the problem is magnified for the investment advisor, who carefully helps his client complete a risk questionnaire, which then suggests more bonds for conservative investors, creating certain losses in market value when interest rates rise — for a conservative investor.  A large allocation to bonds in this interest rate environment is NOT conservative.  Even worse, regulators are schooled in the conventional wisdom and expect advisors to practice conventional asset allocation.

To my knowledge, the famous “BHB” study has not been replicated, but it needs to be suspended until we finally return to a normal interest rate environment.