Careful diversification helps offset losses

By Chris O'Malley
Indianapolis Star

INDIANAPOLIS — Investors in 401(k) plans and mutual funds who are running from a bearish market aren't just dropping equities and climbing the branches of mildly profitable bond funds.

They're all but abandoning certain asset classes and have dashed the diversification needed to offset losses and build decent returns over time.

Allocation of 401(k) balances in stocks reached a record low last month of 57 percent, compared with 67 percent of balances a year ago, according to the Hewitt 401(k) Index. In late 2000, stocks represented three-fourths of plan balances.

"What we're seeing are some things that are diametrically opposed to what they should be doing. No. 1, they're running to bonds," said Michael Scarborough, president of the Scarborough Group, an Annapolis, Md., firm that provides 401(k) education and asset management services.

There's nothing wrong with having some mix of bonds and fixed-income investments in a portfolio. In fact, many investors would do well to boost their future retirement nest egg with a higher percentage of bond funds. For older investors ready to retire, bonds may even be indispensable for income protection.

It's the knee-jerk reactions that have planners and advisers concerned.

"People will abandon their investment objectives and maybe go on a flight to safety. But in doing so, they really don't do it in coordination with their long-term investment objectives," said Harold "Slug" Clemmons Jr., senior vice president and manager of retirement products and services at Old National Trust in Indianapolis.

"People are tired of hearing their broker say, 'hold on.' People are looking to make a change for the sake of making a change. A couple years down the road, they'll probably be sorry again," warned Chris Baker, a principal of Oaktree Financial Advisors in Carmel, Ind.

Mike Storms will take his chances.

"I've spent a couple years waiting for small caps and mid-cap sectors to turn around. I've pretty much decided it's going to be a lost cause, at least for a year of so," said the Pittsboro, Ind., resident, who moved the majority of equities in his 401(k) into a bond fund.

Stan Plocharczyk of Indianapolis is even more daring, moving in recent years to precious metals funds. Sure, he knows gold has been in a bear market of its own for 20 years and that mainstream financial types deride it as an investment for kooks. But Plocharczyk points to what tops Yahoo.com's list of top-performing mutual funds over the last year: gold.

"Diversity," he said, "hasn't worked for the market."

There's some truth to that, at least in recent years.

For example, from 1995 to '98, large-cap growth stocks were the top-performing asset class. Those whose 401(k)s were skewed to large-cap stocks were handsomely rewarded. In 1998 alone, that asset class posted a 42 percent return, according to One Group Investments. To profit, of course, assumes that one had the prescience — or luck — to have loaded up on these stocks.

From 1981 to 2001, someone investing $10,000 of new money on the last day of every year, across each asset category, would have earned $844,380, shows an analysis by One Group. That's substantially better than $684,838 if invested in the top-performing asset category at the end of each year, and $660,371 in the worst.

The diverse portfolio wins.

Baker tells of one client who found out the hard way that diversification was necessary. Against Baker's standard advice, the man weighted his portfolio heavily toward large-cap and technology companies. It plunged 61 percent over the past two years — from $914,823 to $360,343. Baker said that a more diversified portfolio over the same time period, including bonds, would have risen 9.3 percent.

Diversification only goes so far without a plan. Financial planners generally take into account factors such as the number of years until you retire, how much you will need at retirement, how much you can save and level of risk you can stand.

Because the plan is so key, investors must stick to it. That requires a constant rebalancing of the asset mix, something that panicked investors are failing to do.

Rebalancing is simple but deceptively difficult in crumbling markets. If the value of bonds in your 401(k) rises above the 40 percent goal — say they're 50 percent of plan assets as bond funds rise in value — the thing to do would be to sell 10 percent and move it to buy equities.

"If we don't do the same kind of discipline here, where we're selling the portion of our portfolio that is up and moving to the part that is down, we're going to wind up in the same situation two years from now," Clemmons said.