SOME PEOPLE

invest because they want to win. They thrill to the challenge of finding a stock that will double, the possibility of making enough to retire early or just the satisfaction of looking smarter than the guy in the next cubicle. But others invest because they don't want to lose. They're ahead of the pack now living comfortably, saving modestly and want to make sure they stay that way.

This month's column is for that second group. It concerns a simple strategy that comes as close to guaranteeing long-term investment success as anything I've seen. It's strictly do-it-yourself. It doesn't cost much. And it takes minimal time and effort: Once you understand the basics, an hour or so every year is probably ample time to keep your portfolio in order.

This is also a personal story, and its hero is a remarkable man who tumbled into the world of finance in a most unusual way. His name is Bill Bernstein. He grew up in the Philadelphia suburbs, got a Ph.D. in organic chemistry from Berkeley in the early 1970s and then went to medical school. He soon became a neurologist on the Oregon coast, based in North Bend.

Eventually, Bernstein was flying his own plane, taking his wife and three kids on exotic vacations and worrying about his money. Fortunately, he knew more than the typical physician about investing. Bernstein loved math, and his father, an attorney who had worked with bond portfolios, gave him a subscription to the Journal of Finance when he was in high school. While other kids were watching "Laugh-In" on TV, he was learning about modern portfolio theory.

Spread 'Em: Author Bill Bernstein's Ideal Asset Allocation
To maximize the benefits of diversification, you need to own both stocks and bonds and include large-cap, small-cap and foreign holdings. Here's a sample Bernstein portfolio, built around low-cost Vanguard index funds and constructed with a 60-40 stock/bond mix. That ratio should be higher for younger folks (maybe 80-20) and lower for seniors (30-70). Asset allocation works best if you rebalance annually, selling winners and buying losers to keep the overall mix constant. Note that Bernstein's mix of stocks and bonds is much less risky than the S&P 500. It also doesn't track that benchmark closely, which has hurt recent performance. Longer term, however, diversification, low costs and the law of averages are a tough combination to beat.

*A measure of how closely a fund's return tracks the S&P 500, with 1.00 a perfect match.

Returns as of 8/31/00.

Data: Morningstar Principia Pro

In 1993 he came across some research that helped him crystallize his thinking: a study that tracked the benefits of diversification by examining four asset classes (large and small U.S. stocks, foreign stocks and U.S. bonds) during the years between 1973 and 1992. Several combinations of these assets often outperformed their component parts. Bernstein dug up the data and did his own calculations. Even a "simpleton's portfolio" with equal portions of each of the four assets easily beat the S&P 500, at a time when the S&P 500 outpaced nearly all professional money managers. This was powerful support for something Bernstein had learned on his own: The key to successful investing isn't picking the "best" stocks or the "best" times to invest. What is important and relatively easy to control is having the correct mix of assets.

But what assets and what mix? Bernstein was soon spending much of his spare time answering that question. In a couple of years he distilled considerable academic research and years of hands-on experience into a 60,000-word manuscript, written during a long Italian vacation. He then set up a Web site and offered his manuscript for a download fee (now $17.50).

www.efficientfrontier.com was at the bottom of every note.

Curious reporters took a look and were impressed with Bernstein's regular comments on everything from academic research to how to select index funds. Soon they were calling and quoting him in publications such as Business Week and The Wall Street Journal.

Now he has a reputation, a following among financial planners and a sideline business managing about $30 million of other people's money. Bernstein's book came out this fall ("The Intelligent Asset Allocator"), and I recommend it highly particularly if you're someone who invests to avoid losing. As Bernstein builds his case, you'll master statistical concepts such as standard deviation and learn the difference between arithmetic and geometric returns. You'll also realize that even though Bernstein's ideas seem simple, they're based on meticulously rigorous thinking.

To invest Bernstein-style, you first need to be comfortable with the idea that no one can consistently beat the market you included. Bernstein makes a strong case that "star" investors are more likely to be lucky than brilliant, which leads him straight to index funds. They're cheap and widely available. Vanguard, a Bernstein favorite because of low fees and a superb ability to track benchmarks, now offers more than 35 varieties.

Bernstein also enjoys debunking conventional wisdom. The knock on index funds is that they're fine for the S&P 500 but don't make sense for small stocks or emerging markets, where active managers can add value. Bernstein's response is what he calls Dunn's Law, named for the friend who proposed it: When an asset class does well, the index for that asset does even better (large caps in recent years). But when an asset class slumps, the index does even worse. Active managers always stray from a benchmark, explains Bernstein, which keeps them behind when it's up and ahead when it's down. That's why now, when small-stock funds are rebounding, small-stock index funds are doing even better. He's now doing his own series of correlations to test this thesis for nine separate asset classes; so far, results are encouraging.

Read Bernstein and you'll learn much about the benefits of diversification, which are more significant than most investors realize. Stocks have the best long-term returns (about 4%, after inflation, over the past 80 years), but they also have considerable volatility. As Bernstein demonstrates, adding just a few bonds to an all-stock portfolio boosts returns and reduces risk. The key to diversifying wisely is including small investments that tend to be out of sync with the rest of your holdings, such as REITs and foreign stocks.

Slicing up your assets doesn't need to be complicated. Bernstein believes that even a no-brainer mix of 40% short-term bonds, 30% total-market U.S. stocks, 15% small-cap U.S. stocks and 15% foreign stocks is far better than the scattershot portfolios of most investors. The above table presents a more sophisticated mix tilted slightly toward small stocks, value stocks and REITs, sectors that Bernstein favors. For most investors, he likes a 60-40 ratio of stocks to bonds. Naturally, Bernstein advises more stocks (say 80-20) for a child's trust, fewer (30-70) for octogenarians.

The last part of Bernstein's approach is the hardest, mostly because it requires strict discipline. Once you've established a portfolio mix, stick to it. That means adjusting your positions regularly to keep the overall allocation constant. In practice, this becomes a crude form of contrarian market timing. You sell what went up and buy what went down, which often flouts conventional wisdom. There's considerable controversy about how often this rebalancing needs to happen, but Bernstein advises once a year. He believes that regular rebalancing can enhance portfolio returns by about 1% a year. Over time, that's a significant benefit.

One important thing to keep in mind: Implementing his ideas is a snap with tax-free accounts like IRAs and 401(k)s, where there are no penalties for restructuring a portfolio and annual rebalancing. For taxable accounts, however, the cost is often prohibitive. Even Bernstein doesn't recommend asset allocation if it means you'll pay capital-gains taxes.