The Long Run: Pick Up the Pieces of Your Asset Allocation Puzzle

First: The point of this exercise isn't to make you feel stupid. The truth is, most people don't allocate their assets properly. In early 1998, I put all of my Dow Jones 401(k) money in three funds -- they were all, in essence, large-cap growth funds (I felt smart) -- I didn't change my allocation for that account until 2002 (not smart). Harry Markowitz -- the father of modern portfolio theory and one of the great business minds of the past century -- was asked about the asset allocation for his retirement plan. His answer: "I should have computed the historic covariances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn't in it -- or if it went way down and I was completely in it. ... So I split my contributions fifty-fifty between bonds and equities."

Portfolio Pitfall #1: Doing Nothing

"Nobody says at New Year's that they want to smoke more and watch more sitcoms," says Richard Thaler, a behavioral finance professor at the University of Chicago. "Everybody says they want to lose weight and save more, but most people don't."

Inertia is the first impediment to asset allocation. It starts right at the beginning: Everybody gets those enrollment forms when they start a job; studies have shown that less than 50% of all individuals enroll. Interestingly, a study by University of Chicago's Brigitte C. Madrian and UnitedHealth's Dennis F. Shea found that when one company changed its default option to enroll individuals unless they explicitly opt out, enrollments jump from 37% to 86%. "Most people don't want to choose," Thaler says.

In not choosing, people are in effect choosing to retire poor. You can't win if you don't play.

Portfolio Pitfall #2: Failing to Diversify

The 1990s were a lousy time to learn about diversification, because throwing all your money into large-cap stocks was so much more fun and, in the short term, more profitable. "People made some serious mistakes," Bear Stearns Asset Management's O'Shaughnessy said. "They would say, 'I diversify -- I own eBay(EBAY Quote) and Yahoo!(YHOO Quote).'"

Diversification doesn't mean owning six large-cap funds, or four bond funds. You need holdings with a low correlation to one another -- for example, small-caps zig when large-caps zag. You need to diversify across asset classes to balance your long-term risks and rewards.

"Eight to 13 asset classes is optimal," says Ibbotson senior consultant Scott Majeski. Five classes -- large-cap, smaller-cap, international, fixed-income and cash -- is a good minimum.

As the chart below indicates, spreading your assets -- even among two asset classes -- substantially lowers your risk.

On the returns side of the equation, diversifying your assets also means you will get better long-term performance.