Passive Asset Allocation

A while ago I talked about Passive Asset Allocation as a way to beat market return as a strategy. So I'm going to write a bit about what it is, why it works, and how to do it.



Passive Asset Allocation is very simple at its heart. What you are doing is keeping the balance between asset classes that you have decided is best for your situation.



The way you do it is simple. The objective is to maintain a certain investment mix. You allocate your investment pool among the asset classes, and at strict intervals, rebalance to that allocation from whatever has happened over time. Typical period is once per year. You can do it either with individual stocks and bonds, or with mutual funds, variable sub-accounts, or even a mix. For most folks, bonds especially are going to require mutual funds or variable sub-accounts, as individual bonds tend to be high dollar values.



Here's an example, based upon an established portfolio of $100,000. Average market growth is 10%, but it's not evenly spread:



Large Cap growth $10000 @11%=$11100

Small cap growth $10000 @14%=$11400

Large cap value $10000 @14%=$11400

small cap value $10000 @20%=$12000

developing world $10000 @-5%= $9500

developed world $10000 @-2%= $9800

sector investment $10000 @24%=$12400

short bond $10000 @ 7%=$10700

intermediate bond $10000 @ 8%=$10800

long term bond $10000 @ 9%=$10900



The portfolio is now $110,000. Rebalancing (note that this is a taxable transaction unless it's tax sheltered) to the original percentage allocation, we get these returns the next year:



Large Cap growth $11000 @18%=$12980

Small cap growth $11000 @ 4%=$11440

Large cap value $11000 @25%=$13750

small cap value $11000 @ 6%=$11660

developing world $11000 @20%=$13200

industrial foreign $11000 @14%=$12540

sector investment $11000 @-12%=$9680

short bond $11000 @ 6%=$11660

intermediate bond $11000 @ 8%=$11880

long term bond $11000 @11%=$12210



Total is $121000. Seems like right on 10% compounded, right? But look what would have happened if you didn't rebalance:



Large Cap growth $11100 @18%=$13098

Small cap growth $11400 @ 4%=$11856

Large cap value $11400 @25%=$14250

small cap value $12000 @ 6%=$12720

developing world $9500 @20%=$11400

industrial foreign $9800 @14%=$11172

sector investment $12400 @-12%=$10912

short bond $10700 @ 6%=$11342

intermediate bond $10800 @ 8%=$11664

long term bond $10900 @11%=$12099



Total is $120,513. You've added $487 by moving money from where assets were relatively expensive, to where they were relatively cheap.



Let's do it on more year:



Large Cap growth $12100 @-5%=$11495

Small cap growth $12100 @14%=$13794

Large cap value $12100 @-9%=$11011

small cap value $12100 @12%=$13552

developing world $12100 @18%=$14278

industrial foreign $12100 @20%=$14520

sector investment $12100 @24%=$15004

short bond $12100 @ 8%=$13068

intermediate bond $12100 @ 9%=$13189

long term bond $12100 @ 9%=$13189



Total is $133,100. If you rebalanced once per year. If you didn't, here's what you end up with:



Large Cap growth $13098 @-5%=$12443.10

Small cap growth $11856 @14%=$13515.84

Large cap value $14250 @-9%=$12967.50

small cap value $12720 @12%=$14246.40

developing world $11400 @18%=$13452.00

industrial foreign $11172 @20%=$13406.40

sector investment $10912 @24%=$13530.88

short bond $11342 @ 8%=$12249.36

intermediate bond $11664 @ 9%=$12713.76

long term bond $12099 @ 9%=$13187.91



For a total of 131713.15, a difference of 1386.85 you lost in just two years.



This works even better in real world circumstances. Here, I used a larger number of asset classes than most folks use, forced them to be exactly equal, and then forced the yearly returns to average exactly 10% in order to isolate the effects of rebalancing versus not rebalancing from all other concerns. The real market is not so neat. Some years you'll be on top of the world because you gained 40 percent, some years you'll be picking up pennies on street corners because you lost twenty (and it's been better as well as worse than that within the last ten years).



The whole thing that makes this work is that you are moving money from where assets are relatively expensive to where they are relatively cheap at the moment. This is another real world example of the principle behind dollar cost averaging.



It would fall apart if one asset class outperformed all others, or underperformed all others, consistently over time. But this hasn't happened yet. Even in the asset classes that do outperform others over time, the consistency is not there. These classes are volatile. They will do very well one year or two, then do very poorly. When I see or hear people talking about "letting their winners run" over a multi-year period, particularly if they're talking mutual funds or the equivalent rather than a particular security, I know I shouldn't trouble myself about their advice. If an individual security was bought as part of an asset class, that's fine - as long as it still meets the definition of that asset class and you deal with it appropriately.



The one thing that kills this strategy is not sticking to it. "Google has doubled and is still going up!" (or Qualcomm, or Microsoft, or...). The idea is lock the gains in, buy where stuff is relatively cheap. The same asset classes do not do equally well from year to year. It is rare to find one year's superior asset class among the next year's superior performers. This can be hard with individual securities, so most folks who adopt this strategy use mutual funds or variable insurance instrument sub-accounts.



What can sabotage you is a fund company or variable sub-account who will not sit on their fund managers and make certain they adhere to stated asset class. When a Large cap value allocation has forty percent of its stocks in common with a small cap growth allocation, you've got a problem, no matter how wonderful that forty percent performs. It's likely buying apparent performance through demand, which only works short term. One mutual fund company got away with artificial inflation of this kind for about two and a half years back around the start of the decade before the market caught up with them. People are still holding their funds, though, confident that they'll recover because they were doing so well for a while...



Speaking of which, I left financial planning a couple of years ago, but my former clients who did this had amazingly resilient accounts when the market went bust in 2000-2002. Nobody went much below peak account values, and they were all ahead of previous high account balances by the beginning of 2003 (even discounting the effects of contributions). One's balance went from $44,000 to $86,000 over that period with about $10,000 in contributions. Why? Because they didn't let greed rule them.



And before I close, I do need to say that past results are not guarantees of future returns, and this is not a panacea. Consult a currently qualified professional. If an asset class is getting obviously overbalanced or under-represented, it may be time to deal with the situation even though it's only been six months, or one. If you're holding security X, and you keep getting tips on how hot it is, it's probably time to sell.



Caveat Emptor