Investor, know thyself

In the wake of a market crash that devastated most investment portfolios, many people are rethinking how they divvy up their money.

Of the factors under your control that determine your investment performance, experts say, the allocation of your assets among broad classes such as stocks and bonds is the most important -- more crucial than which mutual fund company you invest with or which individual funds or securities you buy.

Here’s the way it’s supposed to work: You settle on an asset allocation that’s right for you and stick with it through the ups and downs of the market.

That didn’t go too well for many people last year, who either spent restless nights worrying about their investments or threw their asset allocations out the window so they could get some sleep.

If that sounds like you, chances are you overestimated your tolerance for risk and need to reassess it (or you hadn’t thought about it), experts say.

“If a bad market causes people to get out of stocks, they had too much in the market to begin with,” said Dale Yahnke, a financial planner in San Diego. “I think a lot of people are reevaluating their risk tolerance.”

Darrell Canby, a financial planner in Framingham, Mass., estimates that since the crash, one-third of his clients approaching retirement age have lowered the level of risk they’re willing to accept.

Of those already at retirement age, he said, about 80% have adopted a more conservative stance.

Data from the bear market demonstrate the importance of asset allocation. Your portfolio’s level of risk -- how much you’ve allocated to the stock market -- was a huge determinant of how much you lost during the market’s slide.

Let’s say that just over two years ago, at the end of the third quarter of 2007, you had 70% of your assets in an index fund designed to replicate the total U.S. stock market, with the remaining 30% in a similarly broad bond index fund. By the end of the first quarter of this year, your portfolio would have been almost 30% smaller.

If instead you had 40% in the stock fund and 60% in the bond fund, you would have lost only 13% during that seven-quarter period. Still painful, but much less so.

The two main criteria for figuring out an appropriate asset allocation are when you expect to retire -- or when you expect to withdraw money from your portfolio for another purpose, such as to buy a house -- and how much fluctuation in the value of your investments you can endure without too much anxiety.

If you won’t need money from the portfolio for a long time, you can opt for a high percentage of stock investments. But the more you’re likely to worry about a market downturn, the lower that equity allocation should be.

It’s not an exact science. Some mutual fund companies offer questionnaires designed to suggest a suitable allocation. You also can hire a financial professional to recommend one.

Once you’ve settled on an asset allocation you’re comfortable with, financial advisors say, it’s important to adhere to it by regularly rebalancing your portfolio -- something many people don’t bother with.

Rebalancing means adjusting the actual mix of investments in your portfolio so it matches your target asset allocation.

For example, let’s say that at the end of 2002, as a five-year bull market was just getting underway, you had 60% of your portfolio in stocks and 40% in bonds. If you did no rebalancing, by the middle of 2007 your stock holdings would have surged to more than 70% of your total assets -- much more than you had planned -- simply because stocks appreciated much faster in that period than bonds did.

Regularly rebalancing can help you maintain what you consider a sufficient cushion of conservative holdings as protection against stock market declines, while ensuring you have enough stocks to benefit from rising equity markets.

Now, for example, many people probably have too little invested in stocks, and as a result have not been fully benefiting from the market’s sharp rebound that began in March.

According to benefit-services firm Hewitt Associates, 401(k) investors on average had 56% of their account assets in the stock market at the end of August. That was up from a low of 47%, reached in February thanks to falling share prices and panicky sales of stock holdings, but still down sharply from a historical average of 67%.

Another benefit of rebalancing is that it helps you to buy low and sell high. That’s because you’re generally adding a little more of an asset class that did poorly and selling a bit of the assets that did well.

If your portfolio is a 401(k) or another tax-deferred account, and you aren’t charged a fee to buy and sell funds in that account, you can rebalance as often as, say, quarterly without unwanted tax effects or extra transaction costs. But if you have a taxable account holding individual stocks and bonds or funds that charge transaction fees, you’ll want to weigh such costs when deciding how often to rebalance.

Many investors find they simply lack the discipline to rebalance. In fact, during the bull market that ended two years ago, some people not only didn’t trim their stock holdings, they actually bought more stocks or stock funds in the euphoria.

“It’s hard to rebalance when the market is going up because, basically, most people are greedy. They want to let it ride,” said Percy Ermon Bolton, a financial planner in Pasadena.

Human nature, said Bryan Hopkins, a planner in Anaheim Hills, doesn’t typically encourage us to sell investments that are hot and buy those that are not.

“To rebalance means you are willing to get off the horse that’s winning the race,” he said, “and get on the horse that’s not winning the race.”

One solution is to invest in mutual funds, known as balanced or hybrid funds, that buy both stocks and bonds.

The keys here: Choose a fund with a specified target asset allocation you’re comfortable with, and make sure that the fund’s managers are required to adhere to that target allocation, or at least stay fairly close to it.

In August and September, such funds as a group recorded net inflows of cash from investors, even as domestic stock funds had net outflows, according to data from the Investment Company Institute, a fund industry trade group.

One kind of hybrid fund is known as a target-date fund, whose allocation gradually becomes more conservative as a designated year approaches. The idea is to choose a fund with a target date close to the year you expect to retire.

Some investors in target-date funds, especially those for people close to or already in retirement, were unpleasantly surprised by the severity of their losses during the crash -- highlighting the need to know how the fund is actually dividing up its assets.

Research firm Morningstar Inc. last month made scrutinizing target-date funds easier when it began rating their performance, fees and management.

Vanguard is seeing a surge of interest in target-date funds along with balanced funds, and expects that to continue, said Fran Kinniry, an investment strategist at the mutual fund giant.

And Hewitt Associates expects that more employers will offer target-date funds in their retirement plans, said Byron Beebe, U.S. retirement market leader at Hewitt.

Another way to force yourself to rebalance is to hire a financial advisor who can do it for you -- or persuade you to do it yourself.

Joe Appolito, a financial planner in Palm Desert, uses a money manager to regularly rebalance his clients’ portfolios. Many of his clients lost significant chunks of money during the crash, but rebalancing shaved several percentage points off the losses, he said.

Larry Petersen, 68, of Irvine was lucky enough two years ago to hire a financial planner who urged him to slash his investment risk. Petersen’s portfolio went from 70% in stocks, with the rest in bonds, to 40% in stocks, with the rest in bonds and so-called alternative assets.

Had he continued to hold 70% in equities, Petersen said, “I’d be broke.”