It's All About Allocation

Any decent fisherman knows that picking the right pond is the most important decision in a successful fishing trip. A similar case can be made for successful investing. Academic studies consistently have shown that more than 90 percent of the performance of well-diversified portfolios is due to asset allocation, not individual stock selection. Even a good angler will have difficulty getting a bite in a bad pond. Likewise, a good security analyst will have difficulty finding profitable investments in a poorly performing market sector.
The overall stock market has displayed dismal performance returns since the first quarter of 2000. The Dow Jones fell from a high of 11,908 to a low of 7,590, the Standard & Poor's 500 fell from a high of 1,552 to less than 800 and the Nasdaq average that rocketed past 5,100 in March 2000 crashed on its way to 1,228 in July 2002. It's hard to find winners in such a market, but again, it depends on where you look. Mid-cap value stock funds actually produced a positive 20.23 percent return in 2000 and small-cap value funds reported an average 19.21 percent in 2001.
Some outstanding individual mutual fund performances also could be found during these difficult times. The Icon Energy fund produced a remarkable 78.65 percent return in 2000 and the Ameristock Focused Value posted an equally impressive return of 60.42 percent in 2001. In other words, they weren't all dry holes in the past two years. It's easy to select good funds after the reports come in, but since mutual fund and market sector performances are not consistent from one period to another, predictions for the next hot sector are difficult.
Many investors get excited when they read about last year's top returns and invest in that market sector, mutual fund or individual stock based on past results. When you make an investment, you are buying the future, not the past. Serious mistakes can result from chasing previous hot performers. In 1999, mid-cap growth stock returns averaged 66.8 percent, only to be followed by losses of 3.83 percent in 2000 and 22.34 percent in 2001; so far, 2002 is indicating further declining values in this sector. ProFunds UltraOTC Inv fund had fantastic returns of 185.27 percent in 1998 and 232.01 percent in 1999 but reported a negative 76.28 percent in 2000 and a negative 69.07 percent in 2001. These results still may appear to be favorable, but remember that a 50-percent loss wipes out a 100-percent gain. If an investor had placed $1,000 in the ProFunds UltraOTC fund at the beginning of 1998, he would have had a fund value of almost $4,300 by the end of 1999. The sad news is that the same investor only would have had $319 if he stayed with the fund through 2001.
Pursuing past performance can lead to a high-risk strategy, but diversification across market sectors can reduce risk because of the variance in sector performance.
 

Dr. Potts, BBA '70, MS '71, PhD '78 (University of Illinois), is professor of finance in Baylor's Hankamer School of Business. He is past chair of Certified Financial Planners Board of Standards (1993).