"Human beings are designed to fail as investors."

If James O'Shaughnessy said that in 1998-99 -- he probably did, actually -- the senior managing director at Bear Stearns Asset Management would've been laughed out of most rooms: cocktail parties, daytrading centers, the set of CNBC. But when O'Shaughnessy uttered those words this week at Ibbotson Associates' 2003 Asset Allocation Conference, the University of Chicago classroom -- filled with investment professionals who paid a grand to attend -- nodded approvingly. They were there because, like most Americans, they feel it's high time to revisit asset allocation.

Let's be honest: Somewhere over the past five years, a lot of us threw away our asset allocation playbook -- or never bothered to read it in the first place. Let's be even more honest: The financial media -- including my two employers during the past five years, The Wall Street Journal and TheStreet.com -- didn't always champion the cause of asset allocation, even though it is the most important factor for every investor.

Consider: A 1991 study by Gary Brinson, Brian Singer, and Gilbert Beebower in the Financial Analysts Journal concluded that asset allocation makes up 91.5% of an investor's return over the course of his lifetime; market timing constitutes about 1.8% and stock selection 4.6% -- yet most investor-oriented publications devote most of their time and energy to short-term, often stock-specific matters that have a negligible bearing on an intelligent long-term investor's portfolio.

As investors, we have spent the past three years paying for our failures -- that's what happens when manias end. If we don't fix it now, we will pay for that mistake when we retire. Investors, wake up from your burst bubble-induced torpor: It's time to get your portfolio's asset allocation in position to succeed for the long run.

The good news is, proper asset allocation doesn't have to be hard -- it's a lot easier than trying to determine a fair price for General Electric ( GE) or Cisco ( CSCO), it involves less work than market-timing, and it's infinitely wiser than letting it sit unchanged (show of hands: who's still 100% large-cap stocks?).

Over the next week or so, I will devote several Long Run columns to asset allocation for the long run. I can say with certainty that a useful asset allocation series is more important -- and, ultimately, more profitable to our readers -- than a year's worth of stories on Cisco, General Electric, and Microsoft ( MSFT).

We will discuss specific asset-allocation models in the coming days -- from the simple to the relatively sophisticated. But it's imperative to begin with an overview of the most common pitfalls of asset allocation.

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) 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.

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

Portfolio Pitfall #3: Failing to Rebalance

A 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
50-50 Portfolio 8% 9.23% 10.84% (-6.89%)
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.

I wish I knew how Graham would advise investors in 2003 -- I don't think it would be 50 S&P 500 index fund-50% bonds. However, it's a good illustration of why diversity and rebalancing matter. In coming stories, we'll discuss better asset allocation options.

Portfolio Pitfall #4: Chasing Performance

When Sweden decided to privatize a portion of its social security system in 2000, it sent out a massive book of 450 mutual funds options from which to choose. One fund was picked much more than the others -- it made up 5% of all the assets, a large sum for a pool of 450 funds. Want to venture a guess? Yep, an Internet fund, which was the hottest offering of the lot. It subsequently lost about four-fifths of its value, according to Thaler.

"People chase performance -- and they are doing it now with bonds," warns O'Shaughnessy. "Long bonds are the next bubble -- unless we get negative interest rates, bonds aren't going to make money."

It is a bit ironic that when people finally do readjust their portfolios, they tend to do it at the wrong time -- going 100% large-cap stocks in 2000, or overweighting long-term bonds now. Don't rejigger your portfolio to follow the crowd -- if anything, you want to boost your exposure to asset classes that have underperformed over the past few years. Reversion to historical patterns is your friend with recent underperformers, and your enemy with hot classes.

Portfolio Pitfall #5: Too Much Money in Company Stock

Did anybody besides me watch The Crooked E: The Unshredded Truth About Enron , that tawdry TV movie? An invaluable asset allocation lesson was contained within: Don't put too much money in company stock.

Sure, we hear the stories about Wal-Mart ( WMT) clerks who are now millionaires because they went 100% company stock, and those Dellionaires at Dell ( DELL). There's a reason why we hear about them: It's extremely rare.

The vast majority of companies fall in between Enron and Dell. One in the middle is Coca-Cola ( KO), where many employees have 80%-90% of their retirement portfolio wrapped up in company stock. The company has been a great performer over the long haul, but in the past five years, its shares have lost about 50% of their value.

"One of the dumbest things individuals do is put $1 more than necessary into their company's shares," said Thaler, who finds many investors erroneously perceive their employer's stock as a separate, safer asset class. Making matters worse: Your livelihood (i.e. job) and your retirement are hindered when the company's fortunes turn sour.

Portfolio Pitfall #6: You Think You're So Smart

"You are not a unique and special snowflake" -- Tyler Durden, Fight Club.

This quote may not be true in all endeavors in one's life. But when it comes to investing, the odds of it being correct are about 99%.

Stock-picking, market-timing, daytrading -- all that stuff was fun and easy in 1998 and 1999. Everything was going up. It was akin to going to the races and having every horse that finished pay off. Here's a rule of thumb: When investing is fun, odds are it's about to get not-so-fun. And the more fun you're having, the more prolonged the not-so-fun part may be for you.

A lot of extremely smart people have attained advanced degrees and work 100 hours a week trying to discern the short and intermediate-term moves of the market. I can't name one who's right all the time. How can we expect to be?

If you really want to prove you're smarter than the pack, invest for the long run. Get started with your asset allocation.

Next week, we'll offer a few asset allocation strategies, from the simple ("lifestyle" funds that diversify your assets for you) to more elaborate (adding sector allocations to increase your long-term returns while keeping risk and diversification in check.) We'll also examine historical trends to try to determine how you should allocate your assets for the next 20 years.

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