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One Simple Trade That Can Boost Your 401 (K)'s Performance And Lower Risk

 November 15, 2012 03:11 PM

(By Rich Bieglmeier) It is estimated that there is more than $4.5 trillion in 401 (K) accounts. More than 75 million Americans use the 401 (k) as a primary savings tool for retirement. While many investors have been putting dollars away for years, the number of choices intimidates many into inaction. (I cannot tell you how many friends and family members have brought me their 401 (k) statements and asked me how to divvy up the money.)

A paper titled ETF PORTFOLIO REBALANCING FOR RETAIL INVESTORS points to research by the Investment Company Institute that shows "a  majority 401 (k) participants did not actively manage their plan assets after making initial investment decisions. This phenomenon is well known in behavioral economics and can be characterized as a status quo bias."

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The status quo bias actually increases the portfolio's risk unbeknownst to 401 (k) investors. According to the paper's author, Teimuraz Vashakmadze, a simple rebalancing approach using two ETFs could help improve returns while reducing risk. The exchange-traded-funds include SPDR S&P 500 (SPY) and iShares Barclays 1-3 Year Treasury Bond (SHY).

SPY seeks to provide investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index. SHY seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the Barclays U.S. 1-3 Year Treasury Bond Index. While your 401 (k) may not offer SPY or SHY, most will have a mutual fund equivalent.

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Vashakmadze constructed three hypothetical portfolios as follows:

a. 75% equities and 25% bonds.

b. 50% equities and 50% bonds.

c. 25% equities and 75% bonds.

And then back-tested results by rebalancing the portfolios on a quarterly, semi-annual, and annual basis.  Rebalancing, for the purposes of the study, is defined as resetting the portfolio mix back to the original percentages. For example, if portfolio a's mix becomes 80% equities and 20% bonds over any of the rebalancing timeframes, investors would sell enough SPY to reset its percentage to 75% and use the proceeds to get SHY to 25%. – make sense?

ETF PORTFOLIO REBALANCING FOR RETAIL INVESTORS found that yearly rebalancing paid off the best, portfolio a generated the highest returns, and portfolio b the best risk-to-reward ratio.

From 12/31/2002 to 12/31/2011, portfolio a – rebalanced annually – generated a cumulative return of 65.15% with a standard deviation of 11.04%. Portfolio b returned 55.86%, and its standard deviation of 7.13% is a little more than half the risk of port a. Finally, portfolio c delivered 43.40% with a tiny standard deviation of 3.46%. Meanwhile, the S&P 500 gained 42.9% in the same timeframe with a historical standard deviation close to 20%.

FYI – standard deviation is how much an investment deviates from its expected, normal returns. For example, ABC Corporation averages 10% annual return with a standard deviation of 8%. As a general rule of thumb, in 67% of the cases ABC will return 2% to 18% (10-8 and 10+8). Ninety-five percent of the time, ABC will provide returns in the range of -6% to 26%, or two standard deviations. We hope that makes sense.

If your 401 (k) suffers from status quo bias, you might consider simplifying things a bit by following the SPY/SHY portfolio that best fits your risk tolerance. The only maintenance required is one trade a year. With the January 1 just a few short weeks away, it could be a New Year's resolution you can actually achieve, and pay off nicely in retirement.

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