Asset allocation funds: an investment strategy that will cost you money

Asset allocation funds are mutual funds that distribute their assets in accordance with all investors’ goals (consistent returns, diversified investments, etc.). Unlike balanced funds, they can shift their portfolio allocations between stocks, bonds and cash in order to capitalize on perceived investment opportunities in any one of those classes.

If a fund’s name includes the term “asset allocation,” it means the fund’s managers, or sponsors, feel that they can enhance returns and/or reduce risks by switching back and forth among stocks, bonds and cash equivalents, often using a so-called “black box” – a computer program that makes trading decisions based on a pre-selected set of rules for interpreting financial statistics.

For example, if the managers feel that the bond market is depressed and poised for an upswing, they may overweight the portfolio in fixed-income investments for a few months to take advantage of the change. Computer modelling makes this investment approach sound scientific, but it is just as likely to detract from a portfolio’s long-term return as it is to add to it.

Asset allocation is overrated as an investment tool. Asset-allocation strategies rose to prominence because the investment industry seized on some academic research on the subject and turned it into a sales pitch for investment products that carry much higher fees than regular stocks and bonds.

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To understand why, apply the “reductio ad absurdum” test. If fund managers could make 10% to 20% a few times a year on well-timed trades, they could probably earn, say, 50% a year for investors. That rate of return would turn $10,000 into $33 million in 20 years, without any additional contributions. Lots of people had $10,000 to invest 20 years ago; few have $33 million today.

Asset allocation funds are like hindsight – they work great when applied to the past, since their creators can tweak the rules to match what actually happened. Asset allocation funds are far less effective at forecasting profits in real time. However, asset allocation funds are always great at jacking up a fund’s expenses, because of the commissions their trading generates. The MER (management expense ratio) that such funds charge can seriously affect returns.

Investors will generally get better long-term results if they stick with this three-part program:

1) Invest mainly in well-established, high-quality, dividend-paying stocks, or mutual funds that hold those stocks

2) Spread your money out across most, if not all, of the five economic sectors

3) Resist the lure of buying stocks when they are in the broker/media limelight. Market setbacks are unpredictable. When they hit, stocks that are or have recently been in the limelight can post particularly deep and staggering losses.

While less glamorous than asset allocation funds, such an investment plan can be cheaper to hold, which gives investors the opportunity to earn higher returns while helping them avoid the potential pitfalls of market timing.

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