Few investors understand the long-term drag on returns that comes with active investing. Even if you guess right your share of the time, the higher volatility that comes from a more concentrated portfolio costs you money. I did a small experiment to illustrate this effect.

Jim started 20 years ago with $20,000 that he planned to invest in only Microsoft and AT&T. He gave $10,000 to one money manager with instructions to always keep the money split evenly between the two stocks.

Jim split the other $10,000 between two money managers, Alice and Betty, and instructed them to decide each day whether Microsoft or AT&T would perform better. Alice and Betty always invested all the money they controlled in one stock or the other. By coincidence, Alice and Betty disagreed every day about which stock would perform better. Each money manager alternated days between being right and wrong.

Based on this setup, the actively-managed money was invested “correctly” exactly half the time and every day one of the pots was invested correctly and the other incorrectly. You might think that the actively-managed money would end up at exactly the same portfolio value after 20 years as the even-split money management.

However, this isn’t the case. The actively-managed money grew from $10,000 to $90,042. But the even-split money grew from $10,000 to $117,918. This shows that the active money managers had to be right more than half the time just to break even. The return boost that comes from diversification is a kind of free lunch for passive investors.

If you have a portfolio with several components that are not correlated and you rebalance among them regularly, doesn't increased volatility give you better returns? The model here might be followed by many unwitting investors but it's not exactly what I would do.

ReplyDelete@Value Indexer: It depends what you are comparing. If you are comparing a rebalanced portfolio in the face of low volatility vs. a rebalanced portfolio in the face of high volatility, then the answer is no, you'll get higher returns in the low volatility case.

DeleteIf you compare not rebalancing to rebalancing, then rebalancing has a bigger advantage in the high volatility case. Essentially, as volatility rises, rebalanced portfolios are hurt slightly less than portfolios that don't get rebalanced.

If by volatility you mean a certain percentage loss followed by the exact same percentage gain, then yes you're losing... But if an ETF has a unit price of $100 today and the same unit price next month, but it drops to $50 in between before going back up, that can be profitable volatility. As long as the rest of your portfolio doesn't go down as much, you have the opportunity to buy more at cheap prices and profit.

Delete@Value Indexer: Volatility has a precise mathematical definition. It's true that sometimes a rebalancing strategy can benefit from volatility. However, on average, higher volatility hurts returns.

DeleteMichael, I do not understand mathematically where does the $28K difference come from. (I suppose your model assumes that all funds are invested 100% of the time.) Could you elaborate a bit beyond "that's what the result is based on the model"?

ReplyDelete@AnatoliN: I've tried various ways of explaining this effect in posts over the years. At its core, this is a volatility effect. When you portfolio goes down 10% and then up 10%, the net effect is a loss of 1% (100 to 90 to 99). Try the same thing with down 20% and then up 20% and the loss is 4%. The greater the volatility, the greater the loss. This comes from the fact that the portfolio is smaller for the upswings than it is for the downswings, on average. Switching back and forth between two stocks has higher volatility than diversifying across the two stocks. Therefore, the more active approach has higher volatility losses.

DeleteMakes sense. thank you

DeleteVery interesting study. Thanks for the important insights here.

ReplyDelete