What is the relationship between the allocation effect and selection effect in portfolio management?

The allocation effect and the selection effect are interrelated components that contribute to the overall performance of a portfolio. The allocation effect refers to the impact of the decision to allocate capital across different asset classes or sectors, reflecting how weightings affect performance in each area relative to a benchmark. The selection effect, on the other hand, pertains to the decision-making process of choosing specific securities within those allocated sectors or asset classes.

Together, these effects combine to influence overall portfolio returns. For instance, if a manager strategically allocates more funds to a sector that performs well relative to the benchmark, this enhances returns based on allocation. Similarly, if specific stocks within that sector outperform, it adds to the returns through selection. Therefore, understanding both effects is vital for evaluating overall manager performance and the drivers of investment success.

This relationship underscores the importance of both investment allocations across sectors and the quality of individual security selections, indicating that a comprehensive analysis of portfolio performance should consider both the allocation and selection effects together.