Wednesday, March 21, 2012

Asset Allocation vs. Consistency

Investors who embrace passive investing often spend a lot of time agonizing over their asset allocation percentages. I used to be no different. However, I now think that sticking to a strategy may be more important than the percentages.

When researchers do back-testing of passive investment returns based on fixed asset allocation percentages, a key assumption is that investors would actually stick to these percentages. However, this is more difficult than it seems.

The truth is that many so-called passive investors reduce their allocations to stocks right after a stock crash and increase it again after stock prices soar. Allocation percentages will naturally rise and fall as stock prices move, but many investors go beyond failing to rebalance; they sell at low prices out of fear and buy back at higher prices. This is disastrous for long-term returns.

Unless you have a far-out plan like leveraging yourself to the eyeballs and dividing your money equally among junior mining stocks, Greek bonds, and hog futures, I think that the ability to stick to a plan is more important than using the perfect asset allocation percentages.

People discuss whether they should have 15% or 20% in an international stock index, but they rarely think about whether they’ll be able to hold on (or even rebalance) through a stock market crash.

2 comments:

  1. Simple yet profound point. The majority of investors do very poorly because they let their emotions control (and change) investment plans and decisions.

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  2. @Ken: Thanks. I doubt that very many investors could admit to themselves that they act out of fear. "I didn't sell because I was scared; I sold because I decided that I had the wrong asset allocation." Unfortunately, if you later decide to change your asset allocation back to your original percentages when stock prices rise again, then you're not tinkering with asset allocation -- you're selling low and buying high.

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