401(k) Performance: Trader vs Rebalancer

Everybody trades, more or less, and I do too. For me, most of the trades were in brokerage accounts with individual stocks. For mutual fund accounts, there were far more buys than sells. But for 401(k) account, so far there seemed to be only buys, no sells. Actually, the only activities in my 401(k) plan besides regular contributions were moving assets among funds within the plan, i.e., reallocating different assets classes to maintain the target allocation (the target itself may change over time as, for example, you are moving close to your retirement).

There are a lot of talks about the importance of rebalancing. And the main argument is to prevent an asset class from growing too big because it’s hot, thus reducing the risk of getting hit hard when it cools off. To rebalance, assets that grows above the target percentage level should be transferred to underperforming areas to maintain the overall allocation target. By rebalancing, you also buy low (underperformers) and sell high (outperformers), instead of buying high and selling low (sell underperformers and add the money to outperformers). For me, since all my taxable mutual fund holdings are with mutual fund companies, rebalancing is not very easy because it can only be done by selling one fund at one company and using the money to buy another fund at a different company and this will incur taxes due to capital gains from the transactions. With 401(k) plan, on the other hand, rebalancing isn’t a tough job as most people have their accounts with a single company and moving assets around won’t have a impact on the tax bill.

If rebalancing is so easy, how many of us rebalance our 401(k) plans? Apparently not a lot. According to David L. Wray, president of the Profit Sharing/401(k) Council of America (PSCA), “The most common employee investment mistake is not rebalancing.” While most of us stay idle with our 401(k) plans, there are a small number of employees on the other side of the spectrum do more than just rebalancing. They actively trade in their 401(k) plans, though the frequency may not be comparable to the trading activities in brokerage accounts.

Now based on the activities in their 401(k) plan, we have three groups of employees: an idle majority, a rebalancing minority, and a small group active traders. How do these groups compare to each other when it comes to 401(k) performance? The answer can be found in a research paper published last month by the Pension Research Council at The Wharton School of the University of Pennsylvania. The paper, “Winners and Losers: 401(k) Trading and Portfolio Performance,” highlights the performance difference between traders and rebalancers based on “a unique new data set of about one million active 401(k) participants in some 1,500 DC plans.” (DC: defined contribution). While observing that “the dominant trading behavior in 401(k) plans is not active or even somewhat inactive trading, but rather nontrading trade at all,” the main conclusion of the study offers the benefits of rebalancing or choosing a lifecycle fund in 401(k) plans:

…… certain types of trading such as periodic rebalancing are beneficial, while high-turnover trading is costly. Interestingly, those who hold only balanced or lifecycle funds, whom we call passive rebalancers, earn the highest risk-adjusted returns.

Furthermore, 401(k) rebalancing is “a particular beneficial strategy on a risk-adjusted basis.”

Passive rebalancers, or investors who hold only balanced or lifecycle funds and leave trading to the fund’s portfolio manager, realize excess annual returns of 84 basis points on a risk-adjusted basis.

while

Active rebalancers, who move their 401(k) portfolio’s equity allocation back to a given target on their own, earn 26 basis points in excess risk-adjusted returns.

For the small group of employees who are actively engaging in trading in their 401(k) plans, the study found that “while some degree of trading is a return-enhancing trading strategy, very high portfolio turnover is not,” and

as a group, traders outperform nontraders when returns are not risk adjusted. But because traders assume higher portfolio risk, the difference in returns between the two broad groups disappears after adjusting for risk. …… Among those who trade, investors who most actively churn their accounts lose 72 basis points per year compared to traders with the lowest turnover ratios.

Finally, the paper suggests that

In view of the clear rewards from rebalancing as an investment strategy, plan sponsors should ask whether using an automatically rebalanced account should become the default. …… since we find that high turnover rates in 401(k) plans harm investment performance, it would appear that discouraging active trading would produce superior risk-adjusted returns and ultimately higher retirement savings.

An example of rebalancing: Suppose that at the beginning of 2005 I set my target asset allocation (Morningstar’s X-ray is a good tool to check asset classes and allocations) as:

  • Large Cap – 30%
  • Mid Cap – 10%
  • Small Cap – 20%
  • International – 20%
  • REIT – 10%
  • Bonds – 10%

that is, I had 90% of my total assets in equities and 10% in bonds, which I think is a proper percentage for my age. At the end of the year, I reviewed my asset allocation and fount it changed to

  • Large Cap – 20%
  • Mid Cap – 10%
  • Small Cap – 25%
  • International – 25%
  • REIT – 15%
  • Bonds – 5%

due to strong performance in the small-cap area, robust growth of economies outside the US (international), and continuous housing boom (REIT), while the large-cap portion, mainly invested in blue-chip stocks, has lagged (not necessarily lost 10% of values, but rather shrank in size relatively). So did my bond investments. To bring the allocations back to the target, at the end of 2005 I had to sell (or transfer) part of my small-cap and international positions to large-cap investments and move some money out of the real estate market (REIT) to buy some more bonds, anticipating a slowdown in the housing market. After the rebalancing, my asset allocation returned to the target percentages and if 2006 turned out to be a good year for large-cap stocks (as it could be from what we saw now), I added some when they were cheap (therefore the return could be even higher) and locked in some gains in small-cap and international stocks when they were hot.

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