Asset allocation

Decades of research at Vanguard and elsewhere has shown that asset allocation—how you divide assets across broad asset classes—is the primary driver of a portfolio's risk and return.

One of the most famous of these studies—Determinants of Portfolio Performance (1986) by Brinson, Hood and Beebower—found that asset allocation accounts for 94% of the variation in returns in a portfolio, with market-timing and security selection accounting for only 6% (Figure 1). Vanguard papers by Wallick et al. (2012),Philips et al. (2014), and Scott et al. (2016) supported these findings. The 2016 paper, The global case for strategic asset allocation and an examination of home bias showed that, over time, the asset allocation decision was responsible for between 80% and 91% of the return patterns of balanced funds available to investors in five global markets: the U.S., Canada, U.K., Australia, and Japan.1


Figure 1. Investment outcomes are largely determined by asset allocation

Source: Vanguard illustration, based on data from "Determinants of Portfolio Performance" (1986) by Brinson, Hood and Beebower.


A portfolio composed of broadly diversified ETFs can help ensure that performance and risk exposure are based primarily on your asset allocation decisions. In fact, holding even a small number of broad-market ETFs can provide a convenient and low-cost way to diversify across asset classes for long-term investors (Figure 2).


Figure 2. Investors can diversify across asset classes with a small number of ETFs.

Source: Vanguard. Hypothetical portfolios are shown for illustrative purposes only and shall not be construed as a recommendation to buy or sell any security or financial instrument, or an offer or recommendation to participate in any particular trading or investment strategy.


Over time, the varying returns of different asset classes will cause nearly every asset allocation to change, resulting in a change to the portfolio's risk and return characteristics. That's why we believe periodic portfolio rebalancing is important. ETFs' trading flexibility and ease of access make them ideal tools for rebalancing a portfolio back to its strategic asset allocation.

Points to consider

  • In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.
  • An all-index portfolio removes the potential for market outperformance that can result from active management or individual security selection.
  • All ETFs are subject to market risk, which may result in the loss of principal. International ETFs involve additional risks, including currency fluctuations and the potential for adverse developments in specific countries or regions. Bond ETFs are subject to interest rate, credit, and inflation risk.

1 Sources: Vanguard calculations, using data from Morningstar, Inc. For each fund in our sample, a calculated adjusted R2 represented the percentage of actual-return variation explained by policy-return variation. The results by country were as follows: 91.1% for the United States, 86.0% for Canada, 80.5% for the United Kingdom, 89.1% for Australia, and 87.9% for Japan. The percentages represent the median observation from the distribution of percentage of return variation explained by asset allocation for balanced funds. For the period January 1990–September 2015, the sample included: for the United States, 709 balanced funds; for Canada, 303; for the United Kingdom, 743; for Australia, 580; and for Japan, 406. Calculations were based on monthly net returns, and policy allocations were derived from a fund’s actual performance compared with a benchmark using returns-based style analysis (as developed by William F. Sharpe) on a 36-month rolling basis. Funds were selected from Morningstar’s Multi-Sector Balanced category. Only funds with at least 48 months of return history were considered in the analysis. The policy portfolio was assumed to have a U.S. expense ratio of 1.5 basis points per month (18 bps annually, or 0.18%) and a non-U.S. expense ratio of 2.0 bps per month (24 bps annually, or 0.24%).


ETF fundamentals