Every investor’s choice: Be the dumb money or the smart money

Investors have a lot of choice when deciding how to handle market fluctuations. Many opt for “tactical asset allocation”—in other words, they move out of stocks, for example, when they think returns will be bad, and move back in when they expect better returns. Many others choose a better strategy—they spread their money among a bunch of different asset classes and let it sit for a long period of time, no matter what the markets do. They tend to earn the market’s long-term returns and do better than the tactical asset allocators. But the smartest group of all takes this buy-and-hold approach a step further: they set up a specific allocation among various types of investments, and each year they put their portfolios back into their original balance by selling a portion of the investments that have gone up and putting the money into the investments that have gone down. These investors tend to earn the highest returns of all, investment studies show.

The tactical asset allocators who chase past performance of asset classes are commonly referred to as the “dumb money” by academics who study the markets. These are the people who throw money into technology stocks or gold after they have soared, and yank it out after they have fallen. These types of investors seem to have a unique ability to invest in stock mutual funds that tend to do poorly afterwards, found a recent study by Andrea Frazzini of the University of Chicago and Owen A. Lamont of Harvard. The researchers found that winning investors do the opposite of what the dumb money investors think will earn high returns. Tactical asset allocators are engaging in a zero-sum game, says Richard Ferri in his new book, “The Power of Passive Investing: More Wealth with Less Work” (John Wiley & Sons, 2011). “When someone underperforms the market it means someone must have outperformed before fees and expenses,” he writes.

From 2000 through 2009 (a period when stock market returns were very low) the average investor earned 1.7 percent annually from all mutual funds, even though the time-weighted return on all funds was 3.2 percent, a recent study by mutual fund research firm Morningstar Inc. Where did the 1.5 percentage point difference go? “Much of it went to brokers, brokerage firms and their trading desks,” Ferri wrote. Some also went to “talented money managers who skillfully separate investors from their money.” A portion also went to buy-and-hold investors who rebalanced their portfolios annually, Ferri argues.

“Investors who lose with their tactical asset allocation strategies indirectly provide excess returns to investors who religiously rebalance their strategic allocation,” he writes. Using data provided by Morningstar, Ferri constructed a hypothetical portfolio held in January 2000 by the three types of investors. By 2009, the tactical asset allocator had earned 1.4 percent per year. The passive asset allocator who did not rebalance their portfolio earned 2.4 percent annually, while the rebalancer’s return was 3.3 percent. “Strategic asset allocation and regular rebalancing provide what is widely referred to as the only free lunch on Wall Street,” Ferri concluded.