What the Investment Industry is Silent On

Efficient Frontier Theory: It's a fact: you can positively impact only one aspect of investment performance—your allocation of assets among broad asset classes. Stock or mutual fund picking and market timing, the things traditionally thought to be critical to investment success, turn out to be almost irrelevant. How can this be?

Over 10 years ago, Gary Brinson, a noted finance academic and money manager, studied a group of pension fund managers. He found that he could explain over 90% of the differences in variability among these investment professionals simply by classifying them according to how much of their assets they placed in stocks, bonds, or cash. Stock picking or market timing skill? Try as though he might, he found no evidence of either among these investors practicing their craft at the apex of the profession. The significance of this for small investors is profound—find the "right" mix of foreign and domestic stocks and bonds, and your choice of individual securities becomes almost irrelevant in the long run.

How the investor arrives at the "right" mix is called "portfolio theory," and until recently small investors had precious little guidance in this vitally important area. How difficult is it to find the "right" mix? Surprisingly easy. Consider this: If over the past 10 or 20 years you had simply held a portoflio consisting of one quarter each of indexes of large U.S. stocks, small U.S. stocks, foreign stocks and high quality U.S. bonds, you would have beaten over 90% of all professional money managers and with considerably less risk. The amazing truth is that over a long enough time period almost any reasonably balanced indexed strategy will best the overwhelming majority of "professional" managers.