Softpanorama (slightly skeptical) Open Source Software Educational Society

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Conclusions

1. Introduction
2. Popular 401K investors delusions
3. Fashionable mutual funds mix
4. Follow the leader
5. Naive siegelism
6. "Financial alchemist" strategy
7. "All money in bonds" or "Depression might start tomorrow" strategy.
8. "Gold always shines bright"  and "Commodities rulez" strategies
9. Lifecycle strategies
10. Economic cycle based market timing
11. Combination of lifetime strategies with market timing.
12. Conclusions
13. Webliography
14. Old News

After reading tons of articles and several dozen of books on the subject as well as spending  many hours on portfolio simulations (which actually improved by Perl programming skills ;-) I became convinced that:

• There is no substitute for self-learning and education for 401K investors.  That is the only antidote for Wall Street propaganda brainwashing and felling victim to media clown/crooks like Cramer.  My notes are just a starting point and in no way should be considered as an investment advice. You need independently verify those recommendation from other sources and against you own intuition.
   

• There is no magic bullet and generally you should expect to get back only those money that you managed to save, beating only inflation.  Or course one should hope for best but it make sense to prepare for the worst: positive returns after inflation for 401K portfolios are not that easy to achieve and elude most 401K investors.
  
  Wall Street and fund managers need to live and live well and that translates into lower returns for ordinary investor. Like in casino, house always wins. There is no free lunch and huge profits of brokers are  taken from investors. There is simply no other source for paying average annual bonuses of $300K or more.  
  
  It should not surprise you that for the period from Jan 1 1996 to Nov 1, 2009  "all-S&P500" investors lost on average 30% in comparison with "all stable value" 401K investors (Vanguard Institutional Stable Value fund was used for benchmarking. ). You can guess where the profits went.
   

• Simple technical analysis based on, say 200 days average (available in graphical form from Yahoo Finance and many other sites) can prevent the most blatant investment mistakes -- buying on top and selling at the bottom.   Technical analysis became less and less useful as you increase the complexity beyond simple statistical measures like average deviation, etc. While stocks distribution is far form normal, stocks deviations from 200 days (and any large then 200 days) simple average better fit normal curve (although fit is far from being perfect) and excessive deviation represents a useful signal that  can warn you when stocks became exorbitantly over/under values (two deviations rule).  When deviation is close of above 2 it make sense to suspend regular contributions positive return on this investment for the next 10 years is very unlikely. If you do not want to do your own Excel calculations ( I strongly advice you doing them yourself as a part of due diligence process), on Yahoo site you can use Bollinger bands with 200 days period and 2 standard deviation as a proxy to see whether contribution to the fund will be profitable in the next ten years or not.  Based on my simulation it makes sense to avoid buying and increase start selling them using cost averaging when deviation is above two.

• There is no relevant statistically significant facts which can demonstrate that "binary" portfolios based on simple  age-based-based stock-bonds allocation or 50/50 strategy are worse that static multi-component stock funds portfolios that are prevalent today if you follow simple technical analysis rules... The key here is keep your portfolio simple so that you can follow the prices movement and react when they got out of hand. There is no sense not to sell stocks when they are exorbitantly overprices or buy then when panic pushed to the exorbitantly low levels. You should not do it all at once, but gradually in chunks not larger 1% (similar to cost averaging)

• You can further sub-allocated stocks and bond holdings of your portfolio but only once (getting no more then four funds in total.) Keeping track about more then four funds is very difficult unless you enjoy it and want to spend extra time on this activity on a regular (at least weekly) basis. If good low cost funds are available (my research suggests that any fund with expenses 1.5 times larger then Vanguard usually is not good) such sub allocation can increase returns.  For example, my statistical simulation had shown that suballocation of bonds portfolio into TIPS and junk enhances returns in comparison with "all-in-one" bonds fund like Pimco Total Return fund. 
   

• In case of static mixes you should be careful with rebalancing: It makes sense to rebalance portfolio only when the discrepancies are more than 20% in comparison with target mix. Blind rebalancing (for example calendar based) can dramatically worsen returns essentially converting them from winning into losing strategies. Several recent research papers advocates “opportunistic rebalancing” of portfolios to enhance returns. See, for example, In Favor of 'Opportunistic Rebalancing' - Seeking Alpha

  Specifically, Gobind Daryanani’s paper, “Opportunistic Rebalancing: A New Paradigm for Wealth Managers” published in the January 2008 Journal of Financial Planning, concludes that a 20-per-cent threshold monitored every second week is the optimal rebalancing strategy. If the target allocation for equities is, say, 60%, no adjustments are made until equities fall outside the threshold band of 48% to 72%. This does not happen often but when it does the biweekly monitoring of the portfolio is sure to catch it and lead to action. The end result is rebalancing that is infrequent but best in terms of capturing buy-low-and-sell-high opportunities, and thus augmenting returns.

  According to Daryanani’s testing of rebalancing strategies on U.S. financial assets over the 1992-to-2004 period, “opportunistic rebalancing” outperformed the widely used five-per-cent threshold band (monitored annually or quarterly) by 0.25 to 0.30 basis points a year. The margin is trimmed after factoring in costs, taxes, and adjusting for volatility, but still positive.

  Note that Daryanani does not adjust asset allocations back to their exact target but to the closest boundary in the tolerance band, defined as equal to 50% of the threshold band. Thus, in the example above if equities climbed past the 72% level, they would be cut back not to 60% but to 66% (effectively, the midpoint between the target and threshold band). 

• Over diversification is a self-defeating strategy.  "Binary" stocks mutual fund/bonds mutual fund portfolio with shares of stocks and bonds close to 50% are statistically competitive with all stocks portfolio and usually has better returns then all bonds portfolios. One reason for it is that it relatively easy for an investor keep track on just two mutual funds and in 3-5 years get experience about typical behavior to avoid most blatant mistakes. Even if they are not necessary better "binary allocations" are simpler, carry less risk that all stock portfolios and save you some fund expenses: after a certain threshold the more mutual funds you own the less is your total return ("overdiversification effect").  You should have some general understanding of the direction of economics and chose (or change to) funds that corresponds this understanding (investing with crowd). It usually does not pay to be a contrarian... As of November 2009 general consensus is that high quality foreign stocks will in the next 5-10 years outperform domestic. That might became a self-fulfilling prophecy.
   

• For the past ten years returns of all S&P500 returns in case of cost averaging are worse and more volatile that returns of junk bonds. In case low cost junk fund is present in 401 portfolio (for example Vanguard High yield" it can serve as a less risky and higher return substitute for S&P500 or similar mutual fund.  That does not mean that you should buy them on the top (for example in August 2008 or November 2009). Like with stocks it pays to wait an opportune moment to enter those funds.
   

• Carrying less risk as you age is the most important return-enhancing strategy 401K investor can apply. Switching to lower percentage of stocks and hight percentage of TIPs in your bond potfolio should be done in discrete stages and each time when stocks are high. Age based investment strategies, even as simple as 100-your_age carry less risks as you age while providing comparable or better returns.
   

• If you try to enhance your returns by going to higher risk investment in your 401K portfolio (as Wall Street PR machine advocates) you should expect to be royally screwed. Wall Street is not a charity and unsophisticated investors are and always will be a legitimate prey.  They manage to screw most 401K investors twice during last ten years so based on this average period before you are fleeced can estimated as being around five years. As old saying goes "A fool and his money are soon parted"