Asset allocation is the primary factor in explaining the variation in the rate of return between different investment portfolios. According to a landmark study by Brinson, Beebower and Singer (and subsequently validated by several others), more than 90% of the total return of a portfolio is derived from the way in which the assets are allocated among the various asset classes. Market timing and actual security selection each contribute less than 5% to the overall investment return on a portfolio.

When designing a portfolio based upon asset allocation principles, there are three primary elements to consider: asset class returns, the volatility of each asset class (standard deviation), and the relative price movement between the various asset classes (correlation).

When analyzing asset class returns, we first calculate the long-term historical rates of return. Additionally, it is very important to understand the relative return between the various asset classes over long periods of time. Understanding this relationship allows greater predictability on how each asset class will contribute to the rate of return on the portfolio.

Measuring and understanding the volatility of each asset class is critical. Generally speaking, the rate of return on an asset class relates directly to the volatility (risk) of the asset class. When measured over long time periods it is generally true – the higher the rate of return, the higher the risk.

The relative price movement (correlation) between the asset classes is the last crucial element in building a portfolio. Combining different asset classes with low correlations with one another will reduce risk in portfolio. This is the heart of diversifying a portfolio.

By considering these three elements and testing them by utilizing sophisticated software, we are able to combine the different asset classes to design an efficient portfolio, one that balances an acceptable level of risk with a statistically predictable range of returns.