By All Means, Diversify

- Alan Lavine and Gail Liberman

This is best demonstrated by reviewing market performance during the three-year and five-year periods ending Sept. 30. The five-year time frame is significant because it covers a period that includes the market peak of early 2000, the subsequent multi-year pullback, the 2003 recovery and the volatility of 2004.

If you had put money in an investment tracking the S&P 500, you would have experienced average annual returns of -1.6 percent during the five-year period ending Sept. 30. For the three-year period, average annual returns would have been 3.43 percent, slightly better, but still well below historical returns for the S&P 500.

By comparison, many asset allocation portfolios performed very well and were much less volatile than major domestic indexes. For example, for the same five-year period, "American Century Strategic Allocations: Moderate" provided average annual returns of 5.02 percent. During the three-year period, the fund returned 6.43 percent annually--a full 87 percent better than the S&P 500.

American Century's Fund isnšt the only asset allocation fund around. You can invest in conservative or moderate funds, or even funds that allocate assets worldwide. The world asset allocation funds had the best track record over the past five years. The average world allocation fund grew at a 6.70 percent annual rate, according to Morningstar Inc., Chicago.

Not all asset allocation funds are alike. Some charge commissions and higher ongoing management fees than others. No-load funds do not charge a commission. Some funds make aggressive changes in their investment mixes. Others make gradual changes based on investment conditions.

In addition, an all-in-one fund may not be right for you based on your financial goals and investment comfort level. You may be better off tailor-making your own portfolio. The reason: You have greater control of your assets. You can offset gains and losses on your taxes. One major problem with mutual funds is that they distribute capital gains at year end. You have to pay taxes on those gains.

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Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books). Al and Gail's new book is Rags to Retirement, (Alpha Books).