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Most stock brokers talk about the advantage of an asset asset allocation strategy which allocates portions of your portfolio to classes of investments (stocks, bonds, cash, large cap, small cap, international etc.) and re-balancing periodically as one class outperforms another and you become over-weighted in it. I found that re-balancing each year got a 0.5-1% / year improvement over a buy and hold strategy and some of this would be eaten up in commissions.

Is it possible that brokers are touting the advantage of re-balancing to get more commissions?

In a landmark study, "Determinants of Portfolio Performance," published in the Financial Analysts Journal (July-August 1986), Brinson, Hood, and Beebower examined the investment results of 91 very large pension funds to determine how and why their results differed.
They determined 94% was due to Investment Policy, 4% stock selection and 2% market timing.
Investment policy was defined as the average base commitment to three asset classes: stocks, bonds, and cash.
You allocated a percentage of your portfolio to each class and as the value of one class went up you rebalanced your portfolio moving assets from the class that went up to the lower priced class. (i.e. sell high, buy low).

In the Jan/Feb 2001 issue of the Financial Analysts Journal, Ibbotson and Kaplan published "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?". They used 5 asset classes: large-cap US stock, small-cap US stock, non-US stock, US bonds, and cash. They confirmed that over 90% of the return was due to asset allocation.

Ken Fisher, Stock guru, says that 70% of long-term portfolio returns are attributable to basic class asset allocation (stocks, bonds, cash), 20% can be attributed to sup-asset allocation (larage/small cap, growth/value, foreign/domestic) and 10% to indidividual security selection.

Everyone has stories of how Aunt Millie made fortune by investing in IBM. And we like to talk about how we bought cisco in 1990, but no one talks about buying MCI in 1999. There's nothing wrong with setting aside part of your portfolio for stock picking, but you may not want to gamble your retirement on picking the next Wal-Mart.

In Asset Allocation in "Investment Strategies for the 21st Century" at InvestorSolutions.com Frank Armstrong says:
"Today, the asset-class decision is more complex than just a decision on stocks, bonds, or cash. Literally hundreds of separate and distinct asset classes could be identified, and more are constantly being proposed. Each has different combinations of risk, reward, and correlation to the others. Putting the asset classes together to meet your goals is where the bulk of the heavy work should be done."

A 2007 Study "Predictable Returns and Asset Allocation: Should a Skeptical Investor Time the Market?", by Jessica A. Wachter, Wharton School Of U. Penn, and Missaka Warusawitharana, of The Federal Reserve Bank, concludes that over the long term investors should resist the advice of those who take extreme positions about asset class allocation.

There are two schools of thought (dogmas) on asset allocation and market timing which are related.
1. Consistent successful market timing is impossible, and asset allocations should only be shifted when your life circumstances have changed.
2. You can predict the performance of an asset class and in the extreme it can pay to shift back and forth between all equities and all bonds.

They concluded that a middle ground approach worked best. i.e. be skeptical of the market timers' claims, but be willing to modestly alter your asset allocation when the evidence in favor of doing so is particularly compelling"

In the following chart classes are listed in order of performance of their market indexes. You can see from the following chart that relative class performance varies widely over time.
(Performance includes dividends)

Source SummitFunds.com

See also Periodic Table of Index Returns 2000-2014)

A Spread Sheet where you can experiment with different allocations and see results.

In trying various scenarios with the spread sheet above for 1992-2006 I found:

  • Re-balancing each year got a 0.5-1% / year improvement over a buy and hold strategy.
    re-balancing gain:
    time   re-balance 
    15 yrs  +0.5-0.7%
    10 yrs  +0.9-1.1%
     5 yrs  no gain to 0.1% loss
  • Selecting the initial mix had much more effect, with results varying from 11-14%. An equal mix of all seven asset classes rebalanced each year gave an average of 11% / year re-balanced return and and a 10.4% buy and hold return over 15 years.
    A mix of 40% NASDAQ-100 and 60% S&P MidCap 400 gave a 14% re-balanced return and 12.9% buy and hold return.
    The best mix with some bonds and international I could come up with was:
    25.0% NASDAQ- 100   5.0% Russell 2000
    15.0% S&P 500 5.0% EAFE Index
    35.0% S&P MidCap 400 15.0% High Yield
    which gave a 12.5% / year rebalanced return and 11.8% buy and hold return.
  • For 10 years (1997-2006) the results were similar. The only mix which did better than a buy and hold strategy of 100% S&P MidCap 400 was a mix of 90% S&P MidCap 400 and 10% NASDAQ-100, which gave a 13.5% / year return.
    The above mix with 5% international and 15% bonds gave 11.1% / year for 10 years.
  • For 5 years an equal mix of all 7 classes produced a 9.2% gain. A mix of 1/3 mid-cap, 1/3 small-cap, and 1/2 internationsl gave 12.6%. The mix of MidCap (60%) and Nasdac (40%), which did good (14% return) for 15 years only gave 7.7% / year for 5 years.
Summary (Annual return over period) thru 2006
Investment 5 yr 10 yr 15 yr
S&P 500 (GSPC) 6.2% 8.4% 10.5%
S&P MidCap 400 (MID) 10.9% 13.5% 13.5%
NASDAQ-100 (NDX) 2.5% 8.1% 12.0%
NASDAQ Composite (IXIC) 4.4%   9.9%
Russell 2000 (RUT) 11.3% 9.4% 11.5%
MSCI EAFE Index (EFA) 15.4% 8.1% 8.2%
High Yield 9.9% 6.6% 8.6%
LB Agg (AGG) 5.1% 6.2% 6.5%
Other index or sector funds
MSCI Emerging markets (EEM) 15.4%    
Real Estate (REITs) (ICF) 13.7%    
Energy Fund (XLE) 16.3%    
Portfolio Re-balanced yearly
Midcap (60%) + Nasdac (40%) 7.7% 12.80% 14.00%
Balanced * 8.4% 11.10% 12.50%
Balanced Equal Mix 9.2% 9.7% 11.0%
The mixed portfolios were re-balanced each year
* Balanced mix - international (5%), bonds (15%), domestic indexes 80%

See charts at the investing page.

REIT - Real Estate Investment Trust

Despite the times that bonds and International outperformed the domestic equity market using them in the mix did not help the long term results. Even at the end of the 2001-02 bear market the Nasdaq and MidCap only mix was ahead.

What this does not take into account is risk; high performing mix certainly had more risk, so depending on your timeframe (e.g. how close you are to retirement) you will want to include some fixed income investments.

My take is that this adjustment of mix according to goals (aggressive for young people and conservative for older people. see below.) alone assumes the market is random. This is not the case and you can get better results by adjusting the mix based on market conditions plus your personal risk tolerance.

For example in 2006 we knew that the Fed was going to stop raising interest rates beause the economy had slowed down and Inflation was not a problem. Also, the dollar was weakening and the U.S. economy was slowing down relative to international economies. Hence it would make sense to increase your weightings for bonds and International no matter which investor group (agressive/conservative) you belong to.

S&P 500 - Widely regarded as the best single gauge of the U.S. equities market, it includes a representative sample of 500 leading companies in leading industries of the U.S. economy, and focuses on the large-cap segment of the market. The median capitalization size of companies in the S&P 500 is approximately $13.2 billion.*

Description of funds:

Nasdaq 100 Index - 100 of the largest domestic and international non-financial securities listed on The Nasdaq Stock Market, based on market capitalization. The index reflects companies across major industry groups including computer hardware and software, telecommunications, retail/wholesale trade and biotechnology.

Nasdaq Composite Index - The Nasdaq that is quoted in financial news.
Includes the over 3,000 companies listed on the NASDAQ exchange.

The S&P MidCap 400 is the most widely used index for mid-sized companies (mid-caps). Today mid-caps are being recognized as an independent asset class, with risk/reward profiles that differ considerably from both large-caps and small-caps. The median capitalization of the S&P 400 companies is $2.7 billion.

The Russell 2000® small-cap Index - Measures is the standard small cap index. It includes the 2,000 smallest companies in the Russell 3000 Index. The index is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set. The median market capitalization of the Russell 2000 Index is $657 million.*

The Russell 2000® Value Index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth rates.

The Morgan Stanley Capital International (MSCI) EAFE Index is recognized as the pre-eminent benchmark in the U.S. to measure international equity performance. It is comprised of 21 MSCI country indices, and tracks large companies in the developed markets outside of North America: Europe, Australasia and the Far East.

The Lehman Aggregate Bond Index (AGG) covers the USD-denominated, investment-grade, fixed-rate, taxable bond market, and includes bonds from the Treasury, Government-Related, Corporate, MBS, ABS and CMBS sectors.

MERRILL LYNCH HIGH YIELD MASTER II INDEX (H0A0) {I couldn't find any quotes under this symbol} The Merrill Lynch High Yield Master II Index is a commonly accepted measure of the performance of high yield securities. The index includes U.S. dollar-denominated high yield Corporate bonds that span the entire high yield ratings spectrum.

Typical classes include:
Stocks: large-cap, mid-cap, small-cap, venture capital microcap, domestic, foreign, emerging markets, sectors (technology, biotech, ), value/growth.
Bonds: Short/long term, Corporate/Govrnment, High yield (Junk), International
Other: commodities, real estate
Managed Futures invest in things like, currencies, stock indexes, interest rates and energies (like crude oil and gas). Examples are Campbell and Grant Park.
Made popular in a landmark study by Dr. John Lintner of Harvard.
They tend to have Low to negative correlations to traditional markets so can reduce volitility.

In "Rational Inveasting in Irrational Times", 2002 Larry Swendroe recommends:
Class % Class %
Domestic (U.S.)International
Large-cap 10 large value 10
Large-cap value 20 small 5
Small 10 small value 10
Small-cap value 20 Emerging markets 5
Real Estate 10
In June 19, 2007 Fortune Ben Stein recommends:
20% Cash, 80% Equities, no Bonds. Equities in ETF's as follows:
25% Vangard or Fidelity total stock fund
25% S&P index fund (VFINX or FSMKX)
25% Overseas market ETF (EFA)
15% Emerging Markets ETF (EEM)
5% Real Estate (REIT) ETF (ICF)
5% Energy Fund(XLE)

Feb., 2007 Money Magazine - Sample Portfolios in "Investing to Win"
Class Young no kids
Young family
single mom
Windfall 62 yrs old
Large Cap 65% 34% 40% 45% 10%
mid-cap   16% 10% 15% 15%
Small-cap 15% 16% 3% 5% 7%
Intl. 20% 22% 25% 15% 14%
Bonds   12% 22% 20% 46%
Real Estate         5%
Other         3%

In "All About Asset Allocation", 2005, R. Ferri recommends:
[to be supplied]

"All About Asset Allocation", 2005, R. Ferri
The Intelligent Asset Allocator, 2001, William Bernstein
"Asset Allocation", 2000, GIbson

The Online Asset Allocator
Asset allocation at wikipedia.

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last updated 2 Aug 2007