The Power Of Passive Investing

April 20, 2011

Investors who lose with their tactical asset allocation strategies indirectly provide excess returns to investors who religiously rebalance their strategic allocation. This occurs because rebalancing naturally forces investors to sell some amount of their better-performing investments and buy more of their worse-performing ones. Although it seems counterintuitive to do this, over time, rebalancing increases portfolio returns and lowers risk.

Strategic asset allocation and regular rebalancing provides what is widely referred to as the only free lunch on Wall Street. It’s a nice thought, but every economics student knows there’s no such thing as a free lunch, especially on Wall Street. Any extra gain in one person’s account means a loss in someone else’s.

The loser in this case is the investor who believes sector rotation strategies and market-timing decisions can beat the market. That investor loses about 1.5 percent return annually according to Morningstar and a lot more according to Dalbar. This loss amount from trading mutual funds is controversial. My opinion is that investors lose at least 1 percent per year from these activities.

Assume three investors each start to invest in January 2000 with a portfolio of 45 percent in U.S. stocks as represented by the S&P 500, 15 percent in international stocks as represented by the MSCI EAFE Index, and 40 percent in bonds as represented by the Barclays Capital Aggregate Bond Index. One investor uses tactical asset allocation in an attempt to beat the markets and underperforms them by 1 percent annually. The second uses a buy-and-hold strategy and lets the portfolio sit over a 10-year period, thereby earning market returns. The third investor rebalances every year for 10 years and thereby outperforms the tactical asset allocator and the buy-and-hold investor. Figure 4 illustrates the outcomes.

The rebalanced portfolio in Figure 4 picked up an excess compounded return of 0.9 percentage points over the market portfolio that wasn’t rebalanced during the last decade. This occurred because rebalancing is a natural way to sell high and buy low without having to make a market prediction.

Figure 4

The rebalancing bene?t varies with market conditions. The bene?t was high in the past decade because the markets were volatile. Over the long term, the bene?t tends to be about 0.3 percentage points net of trading costs.15

This excess return earned from strategic asset allocation represents a real wealth transfer that takes place in the marketplace. This return is enough to make up all the fund fees and trading costs that index fund investors incur, leaving these investors with very close to market returns. You can’t do much better than that.

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