Seven Pillars of Asset Allocation Wisdom

1. Diversification

"Not diversifying is like throwing your lunch out of the window. If you have a portfolio and are not diversifying, you're incinerating money every year." -- Victor Niederhoffer, chairman of Niederhoffer Management.

Diversification is the essence of asset allocation. Many investors in the 1990s held 100% stocks -- some held 100% large-cap growth stocks. Some still do. Others have given up the ghost on stocks and switched to 100% bonds.

That's a big mistake. "You don't want to learn the same lesson again with a different asset class," said Kevin Keefe, vice president and senior consultant at Boston-based consulting firm Financial Research Corp. "You'll get whipped again, just with a different belt."

Investors should have a minimum of five asset classes: Large-cap, smaller-cap, international, bonds and cash. Ibbotson Associates, an authoritative source on asset allocation, suggests eight to 13 classes offer the optimal mix of risk and returns. (Please read this Long Run column on the benefits of proper diversification.)

Finding out your diversification level is fairly easy. The pie charts on your account statements give you a broad understanding of your stocks-bonds-cash allocation. Your best bet is finding a tool online -- such as Morningstar's Portfolio X-Ray -- which allows you to get a more complete picture of all the asset classes.

2. Low Correlation

Spreading your money around five, six, or 15 mutual funds doesn't mean you have achieved diversification. A diversified portfolio means you have holdings that have a low correlation to each other and the broader market.

In other words, they all don't move up or down at the same time. You may feel comforted owning large-cap growth and large-cap value funds, but that's false comfort if those are the only two classes you own. On average, large value and growth funds have a 96% correlation -- meaning they move in tandem nearly all of the time.

Going overseas for diversification is a smart move, but globalization has made foreign and domestic funds more closely correlated than before: According to Financial Research Center, the correlation of the average foreign stock fund to the S&P 500 rose from 36% in September 1986 to 57% in September 2001.