Description: Just as you can’t expect to sit on the sidelines and win the race, you can’t simply reduce the risk in your asset portfolio and expect to make generous returns. There is no free lunch to investing.
One of the primary principles of investing is that there is no such thing as a free lunch. Just as you can’t expect to sit on the sidelines and win the race, you can’t simply reduce the risk in your asset portfolio and expect to make generous returns.
Investing requires patience and discipline to capture returns. A corollary to this principle is that if something seems too good to be true, it most likely is. Below are three examples of strategies that sound good (and can be valid), but a closer look at the costs and risks involved is warranted.
1. Momentum investing: The strategy of investing for momentum1 centers on buying assets that have done well and selling those that have under performed. Studies have shown that momentum in returns exists2, but whether higher returns from momentum investing can be captured is up for debate. In the past, capturing momentum has proven elusive because of trading costs and taxes from the frequent and short-term nature of the required trades. In addition, the constant need to time multiple trades correctly is a heavy burden for the strategist to bear. In many cases, as soon as you think you’re about to capture momentum, the trend reverses. Bitcoin is a great recent example of this3.
There are a relatively few (but growing) number of momentum funds available and even fewer with track records longer than three or four years. A recent Exencial evaluation of these funds showed that nearly all of them were unable to capture a return higher than that of their lower turnover (less frequently trading) growth stock strategy cousins.
2. Rebalancing: This strategy is usually defined4 as a regular, but not too frequent, restructuring of a portfolio’s weights back to a target. A 2014 Vanguard study5 estimated that rebalancing can add 0.35 percent annually to investment returns. It sounds easy and worthwhile, right? Well, rebalancing is fairly counter-intuitive and in some ways is the mirror opposite of the more easily understood momentum strategy. This is because true rebalancing forces you to sell out of sectors that are performing well and buy into areas of the market that have not been performing as well. In this way, you are making a sacrifice by potentially giving up some short-term gain in order to accrue higher expected returns down the line. This is not so easy. Rebalancing takes discipline, but history shows investors have been rewarded for doing so.
3. Taking loans from your 401(k): Similar “free lunch” thinking can be applied to loans, specifically taking loans from your 401(k)6. While this might sound like a good deal – after all, you get to borrow from yourself rather than a third-party and potentially set your interest rate lower than what a bank might offer you — there’s a hidden catch.
As seen in the chart below, a recent analysis conducted by Exencial found that if an average 25-year-old puts $100 per month, plus gets an employer match of $100 per month, into a 401(k) that gets invested at 8 percent, that account will end up with about $431,000 in savings by the time they are 60 years old. On the other hand, if that same 25-year-old diverts their typical 401(k) contributions toward paying off a one-time “self-loan” of about 7,000 over five years, the total amount earned by age 60 will drop to less than $320,000. That’s nearly a quarter of the potential savings, gone.
Source: Exencial Wealth Advisors 401(k) loan study
Participants may be better off taking a loan from and paying higher interest to a bank because of the loss of compounded growth in the 401(k). Of course, some specific circumstances can change this outcome, but it is anything but a slam dunk decision to take a loan from a 401(k).
A healthy investment strategy, just like maintaining a healthy body, requires discipline. In investing, just like with many things in life, the more difficult path often ends up being more rewarding. When you hear about a strategy that sounds like a free lunch, a closer look is probably needed.
1 Investopedia – Momentum investing
2 Seeking Alpha – Momentum investing is supported by academic research
3 Yahoo! Finance – Bitcoin USD
4 Investopedia – Rebalancing
5 Vanguard March 2014 – Quantifying Vanguard advisor’s alpha
6 The Balance – 7 things to know about 401(k) loans before you take one
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