Passive Asset Allocation Traps
A Passive Portfolio
Given that most funds underperform their benchmarks, many people argue that it is probably better to invest in a diversified portfolio of low cost index funds or ETFs and just hold the portfolio for the long term (a passive asset allocation strategy).
A Passive Asset Allocation Strategy Is Relatively Easy to Implement
Sounds logical and simple. After all, a passive asset allocation strategy should be easy to implement. Right?
In theory, yes. It should be easy. All you need is to select the portfolio composition, invest, and rebalance it from time to time.
Portfolio construction is a big topic and not simple. But it is out of the scope of this article. What is left to do is to "passively" manage your portfolio (rebalance it from time to time).
But You Need to Rebalance
The rebalancing part is not that complicated. Many empirical studies show that a semiannual or even annual rebalancing frequency is good enough. Another possibility is to rebalance when the allocation drifts by some amount (for example, 5%). It is a matter of preference. These methods will probably produce similar results over the long term.
Which Can be Hard to Execute
I will give you an example.
Let's say you selected the traditional 60-40 allocation (60% stocks and 40% bonds). Just after you invested, the stocks started falling and, at the rebalancing time, your portfolio is holding 50% bonds and 50% stocks.
The stock market has been falling, you are losing money, and you should sell some bonds and buy some stocks to bring your portfolio back to the 60-40 mix. That sets a trap up.
In these conditions, it very hard to execute the rebalancing. The thing is: if you don't rebalance, you are not really sticking with your passive asset allocation strategy.
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And You Must Stick With Your Plan
The issue is that not many investors can follow a long-term passive asset allocation strategy, especially during difficult times.
Whenever a new down phase begins, most investors start questioning their portfolio strategy, and many decide to change their allocations or even get out completely. Then, when the subsequent up phase begins, they change their portfolios once again to "get back in the game."
Unfortunately, most investors are usually too late getting out and too late getting back in, which is the main reason why they lose money even when the funds they have invested in make money.
Is There a Better Option?
In my opinion, the best way to handle these traps is by implementing a selectively active allocation strategy, which slowly adapts to the market (keeping activity to a minimum and costs low).
Besides making investors' life less stressful, good selectively active strategies are better positioned to generate superior risk-adjusted returns.