Asset Allocation Can Go Too Far

Small-cap value. Real estate. Gold. Emerging markets. Investors chasing trends around the markets generally find themselves investing too much too late.

But in today's volatile markets, investors need to make sure that they have a finger in every pie (or, rather, a fund in every sector) in order to reap whatever gains they can, right?

Wrong.

Investors constantly looking for the perfect asset mix might as well expand their search to include the Holy Grail.

Sure, asset allocation is necessary, but it can go too far. The point of asset allocation is not to always be in the right place at the right time; that sort of market timing is impossible. Sure, gold stocks have doubled in the past 12 months, but they're down 75% since 1987. Real estate investment trusts (REITs) are up 43% in the past two years but down 23% over the past five years. Asset allocation that attempts to capture every sliver of the market defeats the whole purpose of allocating.

The point of spreading your assets over a variety of investments is to enable you to manage the risk and volatility in your portfolio. The larger your portfolio, the more asset allocation helps. But most people overestimate the amount of asset allocation they need, relative to the size of their portfolio.

Finding the Right Mix

Determining the right asset mix should be done in stages. (We're talking about your invested portfolio here; you should keep a cash reserve of at least a few months' expenses in a money market fund, certificate of deposit or Treasury bills.)

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You already know the first step: deciding how much you want in fixed income vs. equities. "That's 50% of the ballgame," says Ed Osborn, a principal with the portfolio management firm Bingham Osborn & Scarborough. "This is the most important decision in asset allocation."

Somewhere around 30% to 40% in bonds is a typical balanced portfolio, although less risk-averse investors with a long time frame (for retirement or for a new home in 10 years) may want more in equities. Those who are more worried about risk or who expect to need the money soon may want to increase their bond allocation.

Determining how to break down your investments within each of those categories, though, is where most investors go overboard.

Equity Allocation

Let's start with equities, because that's where most of you probably begin. The S&P 500 comprises some 85% of the total market's capitalization, making it a good portfolio proxy for the U.S. economy. And whatever its current problems, the U.S. economy is the one to bet on. That means your focus should be on large domestic stocks. For many investors, particularly those with portfolios just under $200,000, this could simply mean an S&P 500 index fund, or perhaps even a total stock market fund.

For investors with portfolios larger than $200,000, Osborn suggests first breaking out a small percentage for foreign stocks, then value stocks and small-company stocks.

Foreign stocks have become increasingly correlated with U.S. large-cap stocks, but long-term investors will still see some benefit from choosing an index fund such as Vanguard's (VGTSX Quote)Total International Stock Index fund, which tracks three Morgan Stanley international indices. Fidelity and Dreyfus also have similar funds: (FAOAX Quote)Fidelity Advisor Overseas and (DIISX Quote)Dreyfus International Stock Index . Over a longer period of time (essentially, through various economic cycles), the differences between foreign markets and the U.S. stock market will temper some of the volatility in each.

That may be the case, says James Glassman, author of The Secret Code of the Superior Investor, but most investors shouldn't consider foreign stocks a separate category in terms of their asset mix. Many large-cap funds hold American depository receipts (ADRs) for the big-name foreign companies such as Nokia, Sony and DaimlerChrysler, and there's not much need for anything beyond those. "Invest in companies, not countries," Glassman says.

As for value stocks, if you're simply buying the S&P 500, you're already buying some value stocks, and that could be all you need. But if you're looking to balance your large-cap holdings, value is a good way to go; and it certainly should be targeted before any industry sectors. Osborn suggests putting 30% of your equity holdings into value stock funds.

Small companies are the third step in equity allocation. With 85% of the market represented by the S&P 500, there's not much need for a huge weighting in small-caps; indeed, you could do without. But Osborn suggests 20% in small-caps because the small-cap indices are not highly correlated with the S&P 500. For instance, the S&P 500 peaked in March 2000, and the S&P SmallCap 600 peaked in April 2002. An asset mix that held small-caps in the past two years would have smoothed that volatility. But since small-caps are generally more volatile, an equal weighting would be unwise.

What about technology, real estate, emerging markets and all the other well-hyped sectors? Many actively managed funds will already be overweighted toward a hot area, and index funds guarantee you'll do as well as the market. Only when a portfolio gets to be larger than $1 million do investors really need to diversify any further. Large portfolios, for instance, could benefit from some exposure to emerging markets or a greater weighting in the real estate sector.

Bonds

Bonds present a baffling array of allocation options for most investors, but the best place to be is in an intermediate-term bond fund -- and make that an index fund. Investors tempted by the flourishing junk-bond market might be inclined to go into a high-yield fund. That's fine; junk bonds do move up and down at different times relative to high-grade government bonds. Junk bonds are less sensitive to interest rate changes but much more sensitive to economic changes. Keep junk bonds to 20% of your bond allocation.

If all of this simplification is making your head spin, consider one fund that's specifically designed to do the asset allocation for you. Vanguard has several "LifeStrategy" funds; you choose how aggressively you want to invest, and choose the appropriate fund. There's also the (VAAPX Quote)Vanguard Asset Allocation fund. This fund's asset mix changes several times a year on the basis of management's analysis of economic data. Fidelity also has its "Freedom" funds, which change the asset mix depending on when you plan to retire. Each fund is named according to the year of retirement it invests for, such as (FFFEX Quote)Fidelity Freedom 2030.

It doesn't get much simpler than that.