Seven Pillars of Asset Allocation Wisdom

Purity, patience and balance are among the successful investor's watchwords.
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"It is a common defect of men in fair weather to take no thought of storms." -- Machiavelli

For most folks reading this article, the past three years have marked the first storm in their investing lifetime -- many neglected to stock up on umbrellas back in 1999.

Three years into the storm, the forecast for the markets isn't great: There's a decent chance the markets will be fairly lousy over the next decade or so.

"From 1966 to 1982, the markets went sideways," says Louis Stanasolovich, founder and chief executive of Legend Financial Advisors in Pittsburgh. "It looks to me like we're in 1968 -- when stocks didn't return very much, middling bonds were barely better and inflation beat them both."

There's a silver lining in the clouds: It's not too late for investors to get some protection.

"Proper asset allocation is one of the hallmarks of investing -- this isn't news," says James O'Shaughnessy of Bear Stearns Asset Management. "But the last three years have reawakened investors to the risks of overly concentrated portfolios. Many have suffered a great deal of pain overallocating to extremely aggressive portfolios."

Stanasolovich, O'Shaughnessy and many others warn that large-cap growth stocks, including the busted technology sector, and long-term bonds -- the asset classes many investors still have too much of -- are going to be weak for the foreseeable future. Investors have two choices: Rebalance their investments now to achieve a reasonable and diversified portfolio, or do nothing and let the long, ugly "reversion to the historical mean" do it for you.

Today, as part of the Long Run's series on asset allocation, we will offer a few examples of solid diversified portfolios for the future. While every investor needs to determine the best allocation for himself, all would be well served adhering to the 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.

Many financial planners recommend adding funds such as the

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Leuthold Core that have very low correlations to the broader market -- they zig when the market zags. Leuthold Core has a 30% correlation with the S&P 500 -- it returned an average 4.73% during the past five years, compared with an average 3.54% loss for the S&P 500, according to Morningstar. Want to know how closely a fund is correlated to a particular benchmark? Morningstar, on its Web site, includes the Modern Portfolio Theory statistics on each fund. The R-squared measure details a fund's correlation with a particular benchmark.

3. Patience

The greatest asset allocation strategy in the world is worthless if an investor doesn't stick to it. "People need to take more of a long-term focus when it comes to asset allocation," Keefe said. "Long-term is not nine months."

Asset allocation, the cliche goes, isn't about timing -- it's about time. Two studies illustrate how a lack of patience undermines individual investors.

A 2001 study by Financial Research Corp. found that the average investor's $10,000 investment in mutual funds over 25 years would grow to $123,000 without any trading, but only $70,000 with trading. The difference: bad timing. Similarly, financial-services consultant Dalbar found that from 1984 through 2000, the average stock-fund investor had an average annualized return of 5.32%, compared with 16.32% for the S&P 500. Once again, active trading -- the average holding period for a fund fell to a hardly long-term 2.6 years in 2000 -- was the culprit.

"Investors should be less active in trading securities and less active in jumping in and out of the market," said O'Shaughnessy. "They should be more active in asset allocation, which they can review on an annual basis."

4. Purity

When hunting for funds in a specific category -- be it large-cap growth, small-cap value, junk bonds or emerging markets -- individuals should find the best performers they can. (Check out our ongoing

Five Funds series that highlights a handful of strong offerings in a given asset class.)

However, buyers beware: Funds don't always live up to their name. As a study from Ibbotson found: "Many mutual funds' stated objective can be vastly different from their estimated style breakdown." The Ibbotson paper pointed to a "small-cap" fund that actually held 35% large-cap stocks.

A fund that deviates from its name doesn't mean it should be avoided -- the long-term winner

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Legg Mason Value Trust, for instance, takes a more aggressive approach that makes it more of a blend of value and growth. Asset allocation-minded investors just need to know what they are buying. Any mutual fund worth its salt will provide a fairly detailed analysis of its style and its holdings on its Web site.

5. Lose Your Overweight

The most common mistake financial planners find in investors' portfolios today remains too much exposure to large-cap companies -- and large-cap growth and technology companies, in particular.

"If you've been frozen with fear, and you're stuck in tech and large-cap growth names, the first thing you should do is reallocate," O'Shaughnessy said.

The second-most common mistake might be overweighting long-term bonds right now, O'Shaughnessy and others say.

A historical examination of returns in a variety of classes is a study in reversion to the mean. Generally speaking, whenever one group has a run of outperformance, it reverts back to historical norms. Right now, large-cap growth stocks and long-term bonds are in the process of coming back to earth. Typically, it takes years. That doesn't necessarily mean that large-cap growth stocks will post negative returns for the next five years -- or that you should get out of them completely. It means that you should at least get back to a normal weighting -- perhaps even lighten up a bit.

Conversely, small-cap and large-value stocks in general look poised to continue reverting to historical means, which means they will outperform. Many investors -- still sporting the same 1999 portfolio -- need to beef up their small-cap and large-value holdings, as well as foreign holdings.

"At the end of 1999, many investors said, 'What ... is this large value thing? Shoot the loser and buy more winners," Keefe said. "That was the wrong thing to do at exactly the wrong time -- many individuals gave up their chance to weather 2000 and beyond."

6. Rebalance

While 99% of individual investors don't benefit from active trading, they should rebalance their portfolio on occasion -- once a year is a fair option. As we

noted recently, most investors never rebalance.

Rebalancing needn't be complicated. If you have a 70% stocks-30% bonds asset allocation, for example, you pare back a little bit of the asset class that has outperformed at the end of the year and add a little bit of the underperforming class to get you back to your 70-30 mix. This ensures that you don't get overexposed to one area -- just as failing to rebalancing in the 1990s meant the large-cap stock weighting in your portfolio got distended.

When rebalancing, investors need to reassess their situation. As you get a little closer to retirement, start shifting some of the stock portfolio into the relative safety of bonds and cash.

7. Know Yourself

A big determinant in an investor's asset allocation is age -- how close one is to retirement. They also need to factor life changes -- junior getting close to college age, etc. -- into their investment decisions. Likewise, there are other behavioral factors that come into play as well.

There are plenty of 30-somethings who went gray early watching their portfolios plunge the past few years. Reportedly asked once what the markets will do, J.P. Morgan replied, "Fluctuate, my boy, fluctuate." The markets have always been a bumpy ride. Investors need to make a clear-minded assessment about how much volatility and how many downturns they can handle.

"If you can't sleep at night, chances are you have too much risk," said Cynthia Meyers, a certified financial planner in Sacramento, Calif.

OK, now that we've discussed the tenets of asset allocation, please check out the

companion story on how to use sector funds to improve your portfolio's diversity and overall returns.