The Power Of Passive Investing

April 20, 2011

The Power Of Passive Investing

The Power Of Passive Investing: More Wealth With Less Work,” by Richard Ferri, hit shelves in December 2010. The book, which includes a foreword by Vanguard founder John Bogle, makes the argument for buy-and-hold index investing based on numerous academic studies, while offering guidance on how to construct low-cost portfolios with index-based investment vehicles.

Chapter 8, “Active and Passive Asset Allocation,” addresses the issue of “timing” by comparing the approaches of so-called tactical asset allocators and passive investors. It is excerpted below.

A key facet of the active versus passive debate goes beyond mutual fund selection into the timing of purchases and sales. Asset allocation is how and when an investor diversi?es among different types of investments in a portfolio. An investor following a tactical asset allocation strategy attempts to beat the market by changing asset class weights using market valuation forecasts or price trends. In contrast, an investor following a passive or strategic asset allocation strategy holds a fixed allocation among several broad asset classes in their portfolio over the long term. Passive asset allocation strategies have proven to be a more effective long-term solution for investors.

Tactical Vs. Strategic
Many investors try to achieve superior returns or reduce risk in their portfolios by varying the allocations among the asset classes at the right times. This method is commonly referred to as tactical asset allocation. To be successful, an investor must rotate money into mutual funds that represent asset classes or market sectors before the superior performance occurs and out of the sectors prior to poor performance. These tactical shifts in allocation can be large or small depending on an investor’s strategy and conviction.

Market timing strategies are a zero-sum game in the marketplace. The ?nancial markets don’t earn any more or any less return just because one person is buying and another is selling. If one investor buys in at the right time it means another investor must have sold at the wrong time.

There is academic precedence that points to measurable losses for investors who frequently trade their accounts. Using recent ?ndings from behavioral ?nance and survey data involving a large sample of online brokerage clients, Arvid Hoffmann, Hersh Shefrin and Joost Pennings found that nearly all equity trading strategies produced lower returns than the markets. Trading based on technical analysis (or charting) was the worst strategy. The raw net results of using trends and other chart patterns to predict returns was negative 0.92 percent per month. Trading based on ?nancial news, intuition and professional advice was the second worst, with a raw net return of negative 0.65 percent per month.1

Many mutual fund investors are also poor market timers. They have a long history of trend-following behavior, similar to the trend-following behavior that Hoffmann, Shefrin and Pennings noted in their study. Fund investors shift money into asset classes that have recently gone up in value and take money out of asset classes that have recently gone down in value. Buying high and selling low has never been a good way to invest. I estimate these tactical asset allocation errors cost investors about 1 percent per year.

Strategic asset allocation is a better strategy. Asset class weightings are set based on investors’ personal needs and only change when their circumstances change. This ?xed allocation of asset classes is maintained religiously through regular rebalancing back to asset class targets regardless of market conditions.

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