Yogi Berra once pointed out that “If you don’t know where you’re going, you might end up someplace else.” Many people when they start investing begin with trying to find the best investment whether that is a stock, bond, mutual fund or ETF. But that is putting the cart before the horse.
 
As Carl Richards, who started “The Sketch Guy” in the New York Times put it in a recent article: “Trying to pick the best investment before you’ve come up with a financial plan is like trying to decide whether to take a plane, train, or automobile on a trip before you’ve decided where you want to go. It makes as much sense as a doctor handing out prescriptions before giving a careful diagnosis.”
 
The Brinson, Hood, and Beebower study published in 1986, and updated in 1991, found that 90% or more of performance could be attributed to the asset allocation decision alone. This means that active investment decisions, such as market timing, sector rotation, and security selection, had a relatively small impact on return variation over time. And, by the way, the portfolios they studied were institutional portfolios, mostly pensions, with investment committees and professional investment managers.
 
In plain language, this means that you can have the best performing stock in your portfolio and significantly lag the performance that you could have had with a properly constructed portfolio which includes a customized asset allocation to meet your long-term goals and risk tolerance.
 
The situation is further complicated by the fact that most people only have a vague idea of both the positioning of their portfolio and its performance, but also that behavioral economics has identified that investors systematically overestimate their portfolio’s performance. Like Garrison Keillor’s fictional Lake Wobegone where “all the children are above average” a large proportion of investors think that they are beating the market. As Daniel Crosby points out in “The Behavioral Investor”:
 
“The authors of “Positive Illusions and Forecasting Errors in Mutual Fund Investment Decisions” discovered that most participants had consistently overestimated both the future and past performance of their investments. One third of those who believed that they had outperformed the market had actually lagged by at least 5% and another quarter of people lagged by 15% or greater. Another study found that investors are unable to give a correct estimate of their own past portfolio performance. Only 30% of those surveyed considered themselves to be “average” investors and the average overestimation of returns was 11.5% per year!”
 
So if we can’t rely on our own intuition, how can we effectively manage our investments? The answer is to start with a strategic asset allocation based upon historical evidence of how markets perform over time. We certainly can’t predict where the market is going, but like what Mark Twain said: “History may not repeat itself, but it rhymes.”