The Error-Proof Portfolio: 6 Asset-Allocation Pitfalls to Avoid

Note: This article is part of Morningstar's December 2014 Better Investment Picking special report. This article originally appeared on September 18, 2014. 

A version of this article appeared on Looking for a hot stock to own for the next few months? An exchange-traded fund that will help you capitalize on trouble in the Middle East? You'll have no trouble finding ideas in the financial media.

Meanwhile, advice on how to apportion your portfolio among stocks, bonds, and cash--while a much more significant factor in your portfolio's long-term performance--is apt to be much tougher to come by. While there's no shortage of commentators who are willing to predict the market's short-term direction, telling investors to set a sensible stock/bond mix and sit tight is inherently less sexy, so you hear much less about the whole issue. 

Thus, it's probably no wonder that investors so often stub their toes on asset allocation. They may let their comfort level with risk lead the way rather than anchoring their decisions in the numbers, not recognize that their situation is an outlier, or employ overly fancy, high-cost tactical asset-allocation strategies that, in the end, may not perform as well as a simple buy, hold, and rebalance plan would have. 

As you're setting your own stock/bond/cash mix, here are six key mistakes to avoid.

Pitfall 1: Not Being Holistic 
Off-the-shelf asset-allocation programs, such as target-date funds, can be a godsend for investors who are just beginning to put together their financial plans. They can provide a reasonable asset-allocation framework given the number of years the investor has until retirement, and they also shift toward more conservative investments as the years go by. The big knock on target-date funds, however, is that they don't take into account other aspects of the investor's financial situation--the type and stability of career path; the presence of other, nonportfolio assets such as a pension; a spouse's assets; real estate investments; and so on. For example, the couple who will be retiring with two pensions that will cover most of their in-retirement living expenses can logically hold a more equity-heavy portfolio than the one who will be retiring without the benefit of a pension. That's because the first couple won't be actively tapping their portfolio in retirement--except for off-budget purchases--so they don't need to be as reliant on more stable assets like cash and bonds. This article walks through some of the nonportfolio considerations that should influence your own asset-allocation plan. If your financial situation is fairly "vanilla," target-date funds or Morningstar's Lifetime Allocation Indexes can be a good starting point when setting your own asset allocation. But if you have something unusual going on--say, a family business or rental properties--you should take those factors into account when setting your stock/bond/cash mix, or seek the help of an advisor who can help you do so.

Pitfall 2: Taking Your Fund's Word for It 
You hold 60% of your money in a U.S.-stock fund, another 15% in a foreign-stock vehicle, and the remainder in a core bond fund. So, your asset allocation is 60% U.S. stock, 15% foreign, and 25% bond, right? Maybe not. Many mutual funds have broad leeway to dabble outside of their namesake asset classes. Your U.S. fund may hold foreign stocks, for example, and your bond manager may be holding significant stakes in cash. Your best read on your own asset allocation, therefore, will be to look into your individual funds to assess their true exposures. You can do that by hand, tallying your individual holdings' allocations one by one and arriving at your actual exposure to each asset class. But a simpler way to achieve the same result is to take advantage of Morningstar's X-Ray functionality using  Instant X-Ray or  the X-Ray tab in Portfolio Manager. That way, when you're checking your asset allocation relative to your targets, you know you're looking at your actual exposures rather than approximations. 

Pitfall 3: Not Factoring in Asset-Location Issues
If all of your money were in a single account, such as an IRA, making sure that account aligns with your asset-allocation target would be pretty straightforward. But for most of us, life is messier: We hold multiple pools of money in company retirement plans, IRAs (both Roth and traditional, perhaps), and taxable accounts. The various tax treatments for each account type argue that investors should not only consider their total portfolio's asset allocation but also "asset location"--which types of assets they hold where. Assets that kick off ordinary income, such as bonds, as well as equities that distribute nonqualified (and higher-taxed) dividends, such as REITs, are best clustered in account types where you're not being taxed on those distributions as they occur. Ditto for high-turnover equity funds (to the extent that you own them), because their short-term capital gain distributions will be taxed at ordinary income tax rates. Meanwhile, common stocks--either individual equities, broad-market index funds, or tax-managed funds--are a good fit for taxable accounts because their tax treatment is more favorable. Those guidelines argue for setting a broad asset-allocation target for all of your retirement assets while being deliberate about which types of assets you place in each account type. After all, as long as the total asset allocation is right, it doesn't matter if individual accounts are more stock or bond heavy. This article details some of the key concepts of asset location. 

Pitfall 4: Being Overly Tactical 
When you first learned about investing, chances are you were incredulous that more investors don't engage in market-timing, increasing their exposure to stocks when conditions look rosy and retreating to more conservative investments when the skies darken. How hard could it be? Pretty hard, as it turns out. Not only are investors often late in running for cover, but they have an even harder time knowing when to get back into stocks once they've fallen. Is the market on the upswing, or is another shoe about to drop? Moreover, investors often assume that market conditions that have prevailed in the recent past will persist well into the future. Morningstar's investor return data generally indicate that investors do a poor job of timing their purchases and sales. For example, they added to their bond exposure from 2009 through 2012, even as equities continued to ascend following the financial crisis. Such timing errors aren't the exclusive domain of individual investors, either. Performance data on professional fund managers who use tactical asset-allocation strategies don't look much more encouraging. While some such fund managers looked like geniuses because they protected on the downside during the financial crisis, such pros have failed to beat a very simple balanced fund over time. 

Pitfall 5: Being Too Hands-Off 
To be sure, the lazy asset allocator is often more successful than the busy one. But unless you've decided to be completely hands-off and have purchased a target-date fund or some other all-in-one portfolio that you plan to own for many years, there's such a thing as being too hands-off. You'll improve your portfolio's risk/reward profile (and especially its risk level) by periodically rebalancing your asset-class exposures back to your target levels--that is, scaling back your exposure to strong-performing assets and adding to your underperformers. And assuming you plan to spend the assets in your portfolio during retirement, your targets themselves will change over time--you'll need to nudge up your exposure to conservative asset types as your retirement draws near. I recommend that investors employ an investment policy statement, and then conduct an annual portfolio review in which revisiting asset allocation is a key objective. 

Pitfall 6: Letting Your Risk Tolerance Drive Your Portfolio Mix 
Some financial calculators quiz investors on their risk tolerance--their ability to withstand short-term losses--as a means of helping them set their asset allocations. And indeed, the growing body of research in behavioral finance suggests that investors can undermine their portfolio's performance when they're stressed out; a portfolio plan that makes perfect sense on paper won't be successful if the investor scratches the plan when the markets get stormy. Yet, investors should also be careful not to confuse their risk tolerance with their risk capacity and should let the latter drive their asset allocation much more than the former. Risk capacity relates to the investor's ability to withstand losses without having to change their goals or their standard of living if they're retired: Because of their longer time horizons, young investors have much higher risk capacities than do their older counterparts. Meanwhile, older investors might feel risk-tolerant--they may even be comfy holding a 100% equity portfolio--but incurring big losses, especially early in their retirement years, could deal their portfolios a blow from which they may never recover. This article discusses the importance of keeping the focus on your risk capacity, not your risk tolerance.

See More Articles by Christine Benz