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 DiversifyThe 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) and Yahoo! ( YHOO).'" 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.
Portfolio Pitfall #3: Failing to RebalanceA 1988 study of TIAA-CREF participants found the median number of asset allocation changes and rebalancing by an individual over his or her investing lifetime was zero -- never! More recent studies have yielded similar results. This is incredibly silly, but it is true. Over every 20-year period, stocks return an annual average of about 7.2% -- but in the short term, markets are incredibly volatile, which can totally disrupt an investor's asset allocation. For instance: Let's say your asset allocation in 1994 was 60% stocks, 30% bonds and 10% cash. If you didn't rebalance, by the end of 1999 your asset allocation would have been 78% stocks, 17% bonds and 5% cash. To show the benefits of a little diversification and rebalancing, I asked the good folks at Vanguard Group's statistics department to determine how a 50%-50% portfolio -- the 50% stocks represented by the ( VFINX) Vanguard 500 fund, the 50% bonds by the ( PTTAX) Pimco Total Return fund -- would have performed over the past seven and 10-year periods, provided investors rebalanced back to 50%-50% at the end of each quarter. I chose 50%-50% for simplicity's sake, and also because that's what Benjamin Graham advised investors in 1972 to do -- I'm guessing he wouldn't advise 50% large-cap stocks and 50% bonds in 2003. (Side note: Reading The Intelligent Investor is probably one of the two or three most important things an individual can do to ensure a successful investing lifetime -- if everyone who bought Dow 36,000 in 1999 purchased this book instead, it would've saved a lot of heartbreak.) Here are the results for the 50-50 portfolio, compared with an all-stock portfolio and an all-bond portfolio.
|The 50-50 Exercise |
A regularly rebalanced portfolio offers a better risk-return option for investors with less volatility*
|Portfolio||Average Annual Return for Seven Years (1996-2002)||Average Annual Return for 10 Years (1993-2002)||Best Month||Worst Month|
|100 Stock (Vanguard 500)||6.82||9.27||21.39||(-17.22)|
|100 Bonds (Pimco Total Return)||7.94||8.3||6.5||(2.69)|
|Source: Vanguard. *Returns are after expenses, but don't factor in Pimco's front-end load.|