Editor's note: This is the third of four columns in which Vern Hayden discusses current mutual fund investment strategies. In the first two installments, he looked at funds with multiple star managers and funds of funds. Today he examines classic asset allocation. Still to come: timing strategies.

Asset allocation is like wearing protective gear in athletics. You feel like you could score more points if you weren't hampered by all the awkward equipment. But without it, one hard blow to a kidney or your spine, and your life is changed forever.

In the market, you are never quite sure where your portfolio is vulnerable, so you have to protect it. There are lots of ways to do that, though none are perfect. When you are putting together a portfolio, keep two important things in mind: Your portfolio should return enough so you can reach your financial objectives. And it should do so with a degree of risk you can sleep with.

To achieve these objectives, you are virtually forced to work with different classes of assets. The minute you do that, you probably will end up with "protective" gear that will cause underperformance in bull markets but cushion your portfolio to some degree in down markets.

What is an asset class? An asset class includes investments whose behavior is similar during changes in economic circumstances. There are a number of possible asset classes to consider, such as cash, stocks, bonds, real estate and commodities (e.g., gold).

In every class of assets, there are subclasses. For instance, with stocks, there are large, midsize and small companies. There also are growth stocks and value stocks. If you could pick the best-performing class at any given time, you would have the greatest return, but probably the highest risk as well. That's the frustrating part. Like the old adage says, you shouldn't put all your eggs in one basket.

To control risk and still reach your financial goals, it is necessary to allocate your money to different classes. Each unique asset class will hopefully offset the weakness of the others and complement their strengths. An effective portfolio is not just the sum of its parts, but it must include the interaction between those parts. Hopefully, this interaction will reduce risk and volatility in a portfolio while still making it possible to achieve the returns you need to reach your financial goals.

A more sophisticated definition of some of these concepts is contained in the school of thought called Modern Portfolio Theory. I won't go into this theory in detail. It's enough to say that some of its concepts permeate the common-sense approach I am trying to give you.

Roger Gibson, author of

Asset Allocation: Balancing Financial Risk

, put it this way: "The goal is no longer to beat the market, but rather to devise appropriate long-term strategies that will move clients to their objectives with the least amount to risk."

Harold Evansky, a great thinker, innovator and leader as a financial planner, wrote an 89-page book recently called

Y2K and Your Money

. This is a must-read for people concerned about Y2K and investments. But the book isn't just about Y2K -- it includes a very concise summary of asset-allocation issues. Harold writes, "It has been demonstrated over and over again that the appropriate mix of assets is by far the most important factor in determining the variation of your investment return." More on some of Evansky's thoughts next week. (By the way, I do not get any royalties and am not in Harold's will!)

Some advisers use a "black box" approach in determining their clients' appropriate allocation. These software programs ask a lot of questions, quantify the answers and find the most efficient frontier for investors. An efficient frontier consists of the best mix of stocks, bonds or cash given an investor's risk tolerance. Keep in mind, though, you can't program into a black box the many subjective judgments that are part of understanding an investor's situation. The box is almost like a video game that can be fun to play, but if taken as the final answer, could actually be dangerous for your portfolio.

Next week I will discuss the extremely important issue of risk and a 50-year history of stock/bond allocations and their returns. This will be extremely helpful in building an "efficient" portfolio.

More on Funds of Funds

Bob Markman runs three funds of funds and also is president of the Fund of Funds Association. Bob sent an email in response to last week's

column, in which I said, "If you are willing to do some active managing of your own, you probably can do better" than funds of funds.

Markman wrote:

Most observers have, by now, learned that a fund of funds is a substitute for a self-selected diversified portfolio of funds. As a surrogate for a portfolio, it will invariably contain funds from a range of asset classes. In a typical fund of funds, you may find a mix of bonds, cash, large- and small-caps, internationals, etc. So where is the intellectual rigor of comparing the performance of these types of portfolios to the S&P 500? Come on, Vern, you know better than that. In your personal practice, where you no doubt construct diversified portfolios for clients, do you expect those clients to judge your diversified mix against the S&P? Why do you place that apples-to-oranges comparative burden on funds of funds? The reality, if you cared to do the research, is that there are any number of funds of funds that have done an excellent job creating diversified portfolios for investors who chose not to do it themselves. Check out the FOFA Web site, www.fundsoffunds.org . The facts speak for themselves. I fear that your bias and agenda as an investment adviser is showing.

Again, I want to make it clear, I have a bias as an adviser to pick my own funds. Qualified self-investors probably feel the same way. As to the comparisons to a benchmark like the S&P 500, it is my understanding that some do have that objective and some do not. For clarification on my feelings about benchmarks, please see my Jan. 6 column,

The Only Benchmark That Counts: Your Goals. I do agree that some funds of funds could serve as core holdings, especially for investors who do not want to pick their own funds.

Vern Hayden is a certified financial planner with the American Planning Group in Westport, Conn. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. Hayden welcomes your feedback.