Imagine three bears walking through the woods in search of a honey-drenched beehive. Instead, they come across three computers displaying their 401(k) holdings. (Yes, it's a stretch. Just bear with me for a minute.)
Papa Bear starts to look over his returns, gets distracted by some squirrels, and wanders away. Mama Bear looks over her investments, decides she can do better, and starts trading all her funds. Baby Bear sees that managing a 401(k) could take up time he'd rather spend rolling around in the leaves, so he parks his money in a fund that will automatically allocate his assets according to a formula that becomes more conservative as he nears retirement.
Which bear earns the best returns in this far-fetched fairy tale? It's Baby Bear, according to a study by scholars at the Vanguard Center for Retirement Research and the Wharton School at the University of Pennsylvania. The formula strategy, as it turns out, is just right.
The researchers looked at the performance of more than a million active 401(k) accounts during 2003 and 2004. They wanted to know whether traders or nontraders earned better returns on their 401(k) investments.
Too hot or too cold
First, they found that most people act like Papa Bear (who was last seen with his head in a trash can). About 75% of 401(k) holders basically ignored their accounts during those two years.
Among everyone else, the active traders outnumbered people who simply rebalanced their accounts to make sure their investments reflected the asset allocation they had originally desired. Among the people whose trades only rebalanced their accounts, about twice as many people simply picked funds (like life-cycle funds or balanced funds) that took care of that task for them. In fact, researchers said it was a "rare breed" of investor who actively rebalanced his or her 401(k) holdings, accounting for only 3% of those studied.
So how did all of these investors fare? When comparing risk-adjusted returns, the study found that the returns of active traders were no different than the returns of nontraders, those people too distracted by the squirrels to pay any attention to their accounts.
People who picked funds that took care of their rebalancing chores for them reaped the highest returns, earning 0.84% per year more than those of the nontraders. People who rebalanced their accounts on their own achieved returns that were 0.24% higher than returns from doing nothing.
Be Baby Bear
It seems that picking an asset allocation and sticking with it -- either through passive or active means -- wins the day. Both avoiding trades entirely and trading too much can be detrimental to your account returns. So how can you join Baby Bear and get the best returns on your account?
Rebalance. Keep an eye on your investments and rebalance when your asset allocation gets too out of whack. You don't need to do this frequently, just consistently. Researchers said that it looked like do-it-yourselfers could profit from paying closer attention to their holdings. If you know you're likely to ignore your account once you've set it up, consider investing in funds that keep your investments in balance for you.
Stop trading. Avoid trading too much, as active swapping can prove costly.
Get off the computer. The researchers found active traders tended to be more likely to have web access to their accounts. If that's you, resist the urge to keep checking on your holdings and moving your money around. Check in on your fantasy sports leagues instead.
Narrow your investments. The study found that plans offering lots of investment choices encouraged active trading. If that sounds like your plan, review your options but narrow your choices. Establish a strategy and stick with it instead of chasing the latest returns of every fund offered.
Opt for index funds. People who invested in index funds were more likely to rebalance their accounts, perhaps because they adhere to a buy-and-hold philosophy. Index funds, among the Fool's favorites, typically offer broad diversification and low expenses.
The superior returns of the rebalancers led the researchers to consider that the best plan might be one that rebalances your account for you. In the meantime, join the rare breed who take this task on themselves, or pick a fund that does the work for you. Then you can join the bears and go frolicking in the woods. Just don't eat their porridge.
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