What you believe about how markets work has a meaningful impact on long-term return. Do you believe markets are relatively efficient or do you believe there are ample opportunities for excess profits? Your beliefs drive investment strategy and your strategy drives portfolio performance.
Big picture beliefs about investing can be divided into two categories. First, whether you believe individual stock and bond selection has a reasonable chance for outperforming their respective passive market benchmarks. Second, whether you believe markets returns are predictable enough so that excess returns can be earned by shifting asset classes at the appropriate time.
Figure 1 provides a visional representation of these two choices. The left top represents the two security selections methods (passive and active) and the left side represents the two asset allocation methods (fixed and tactical).
Figure 1: Four Portfolio Management Beliefs
Let’s start with asset allocation because it’s been my belief that most people decide to invest in an asset class type before they seek a fund that represents the asset. For example, an investor typically decides to buy a U.S. stock fund before they decide the type of U.S. stock fund.
A fixed (or strategic) asset allocation follows a specific target mix based on an investor’s long-term needs. Often this allocation consists of a simple mix between stocks and bonds, and is then further refined using sub-asset classes such as developed international stocks, emerging markets, Treasury bonds, corporate bonds and so forth.
Rebalancing keeps a fixed asset allocation aligned with its target mix. Rebalancing can occur based on a calendar method or a percentage of asset method. The calendar method requires investors to rebalance portfolios once per year on an investment anniversary date. The percentage of asset method requires more work because frequent portfolio monitoring is needed to determine when asset classes move outside of their tolerance bands. For example, a portfolio that is allocated to 60 percent in stocks and 40 percent in bonds might be rebalanced when the stock allocation rises to 65 percent or drops to 55 percent.
Tactical asset allocation attempts to achieve superior portfolio returns over a fixed allocation by varying the allocations among asset classes in a timely manner. To be successful, investors must rotate money out of asset classes they expect will earn poor returns in the future and into those where they expect greater opportunities. By default this strategy implies that an investor has more superior information than the rest of the market – otherwise, they would not be able to make superior market calls.
Tactical asset allocation has a higher maintenance cost than a fixed allocation and this puts the strategy at a disadvantage from the start. A tactical strategy implies moving money around more frequently than a passive buy and hold approach and this leads to higher trading costs. These excess costs can be high for aggressively-traded accounts. Tactical asset allocation strategies may also lead to higher tax expense in a taxable account.
There is a second cost that must be mentioned that is specific to tactical asset allocation. It’s a behavioral cost. Several studies of mutual fund rotation points to investor bias when selecting an asset class. People tend to buy into asset classes after they have gone up and sell them after they have gone down. Morningstar has studied this bias as have DALBAR, Vanguard and other companies. In aggregate, the cost to investors appears to be in excess of one percent per year.
The second decision we make as investors is fund selection. Perhaps you believe the markets efficiently price securities based on the expectations of all investors. This may lead you to buy passively-managed low-cost index funds that track benchmark performance less a small fee. Or perhaps you believe that money managers have an edge over the market and can select individual securities that outperform indexes. In this case, you would buy actively managed funds.
I’ve written extensively about the active versus passive debate within the mutual fund industry. Some people believe that active funds have an edge over index funds, at least in some categories. They would invest in active funds using either a fixed allocation or tactical asset allocation strategy (boxes #3 and #4) I don’t find this to be true in the long-term. Index funds eventually appear in the top quarter of all fund categories, particularly since many active funds close each year. A passive fund investor would invest in index funds using either a fixed allocation or tactical asset allocation strategy (boxes #1 and #2).
The evidence for all index funds all the time is overwhelming. While it is possible that a portfolio using all active funds will outperform a portfolio using all index fund, it’s not probable, and the odds drop over longer time horizons and as more fund categories are added to a portfolio.
I follow a fixed asset allocation using passive index funds (box #1). This is the lowest cost and least speculative investment strategy of the four methods. It also eliminates the behavioral cost created by moving money around within asset classes.
Figure 2 represents the expected returns from each of the four strategies. Box 1 represents a neutral return, meaning it is the benchmark for the other three boxes. Each box’s expected return is relative to the Box 1 return.
Figure 2: Expected Returns of the Four Portfolio Strategies
Investing is an exercise in probability. We have only so many years in our lives and must choose an investment strategy that has the highest probability for long-term success. A fixed allocation using index funds has the highest probability among the four investment strategies.
Before closing, which beliefs have the lowest probability for investment success? You might answer Box #4 because of fees and biases. I would argue that it is not.
The worst returns will go to investors who have no beliefs. When a person has no investment principle to latch onto they become fish bait for Wall Street. These investors tend to move randomly from one strategy to another without a long-term vision. This turnover in strategy creates a very high behavioral cost.
It’s my view that the markets are relatively efficient. I do not believe there are ample opportunities to earn excess profits from picking active funds or engaging in market timing. Your beliefs will have a meaningful impact on your long-term return. They will drive investment strategy and this ultimately drives portfolio performance.