How Many Mutual Funds Should You Have in Your Investment Portfolio?

How Many Mutual Funds Should You Have in Your Investment Portfolio?
Time to take an inventory of your mutual funds. How many are there? What are their investment styles? Is your portfolio of mutual funds cluttered just like your closet? Have you owned some mutual funds so long that you have forgotten why you bought them? Are there some mutual funds on the top shelf, way in the back of your financial closet you haven't even looked at in a while?

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Adding new mutual funds to your portfolio is far easier than reorganizing your fund portfolio and discarding inappropriate, redundant, or simply poor-performing mutual funds. The answer to the question of how many mutual funds you should have in your portfolio is not just a number. But if you have many more than eight mutual funds in your closet, chances are you need to do some serious portfolio cleaning. Here's why.

First, in order to be well-diversified, your mutual fund portfolio should be invested in domestic and foreign stock mutual funds and in fixed-income mutual funds or income fund equivalents. Within the domestic stock market, your mutual funds should cover large stocks, small stocks, and stocks in-between.

Foreign investments should cover established firms in industrialized countries and stocks of countries that would be considered emerging markets. While geographic diversification domestically is relatively unimportant, diversification by region for foreign investments is. Representation in Europe for large stock international mutual funds is important, and investments in Latin America and the Pacific Rim are crucial when considering emerging stock mutual funds. Global mutual funds that invest domestically and abroad sound like a one-fund answer, but it is too much geography for one portfolio manager to cover and global funds tend to change domestic/foreign portfolio weights as world conditions change, neutralizing some diversification benefits.

Counting the Mutual Funds

Let's stop and take a count: one large stock domestic fund, one small stock domestic fund, one international large stock fund, one emerging market stock fund—so far, four mutual funds. Have we missed the mid-sized domestic stocks? Well, check your large-cap stock fund and your small-cap stock fund to see what they include. Usually, large stock funds leak down into the mid-size range and small stock funds push up into the mid-size range. If not, add a mid-size mutual fund to avoid any portfolio gaps. Now we may be up to five, all of which are stock mutual funds at this point.

If you want income and the diversification benefit of a fixed-income fund, then a simple choice would be to consider intermediate U.S. government bond mutual funds. The intermediate maturity—in other words, a three- to 10-year weighted average maturity for the bonds in the portfolio—captures most of the yield of longer-term mutual funds with much less volatility when interest rates change. If you are in a high federal tax bracket, a municipal bond fund might be a better choice. And if you live in a state with high state and local taxes such as California or New York, you may want to consider substituting a state-specific municipal bond fund to minimize federal, state and local taxes on the bond income. Aggressive investors can reach to high-yield corporate bond funds and if they are in a high tax bracket, hold the fund in a tax-sheltered account. While high-yield (junk) bond funds invest in lower-quality corporate debt that pays high income, the individual default risk of the bonds in the portfolio is softened through diversification and the high income dampens portfolio volatility. Furthermore, high-yield bonds tend to be sensitive to the economic cycle, acting more like stocks than government bonds.

One bond mutual fund in a portfolio may make sense, but it is difficult to imagine the value of more than two bond mutual funds. For high-tax bracket individuals, a municipal bond fund and perhaps a high-yield bond fund in a retirement account may make sense, but high-tax bracket investors often prefer growth through common stock mutual funds rather than income from any source.

So, if we add one to our fund count for a fixed-income fund we have a total of six mutual funds; two bond funds would push it to seven.

Other Categories of Mutual Funds

What about all those other categories of mutual funds? Do you need a gold fund, mortgage-backed bond fund, international bond fund, sector fund, index fund?

Let's take them one at a time.

• Gold mutual funds are concentrated sector funds holding gold mining stocks primarily in North America, South Africa, and Australia. They are extremely volatile, as gold price changes are magnified by the operating cost breakeven points of gold mining firms. Do you need a gold fund in your portfolio? No. Most investors use gold funds as a store of value, a hedge against inflation. Over the last decade, however, they have been neither. When stocks are roaring up, you would like your gold fund to behave like a stock, but it tends to act like gold bullion. When the stock market collapses, you hope your gold fund behaves like gold bullion, but unfortunately, it tends to act more like a stock.
• Should you consider mortgage-backed bond mutual funds for your portfolio? Probably not. A diversified portfolio of mortgages that promise higher returns than a U.S. government bond portfolio of similar maturity does have some appeal. However, mortgage-backed funds have at times behaved as badly as gold funds. When interest rates rise, bond prices fall and the share prices of bond mutual funds also fall. So, as an investor, when rates rise, you want a mortgage-backed bond fund to act contrary to a bond, but it doesn't. When interest rates fall, the prices of bonds and bond mutual funds rise, but a mortgage-backed bond fund will respond more to the mortgage market. When mortgage rates fall along with interest rates, mortgages are refinanced and part of your investment is essentially handed back to you to be reinvested at lower rates.
• International bond mutual funds often promise higher yields, but the difference in yields is usually due to differences in currency strength. A country with high interest rates is likely to be protecting a weak currency. When rates are high, investors buy the currency to buy the bonds and support the currency in the process. If the currency in which the foreign bonds are denominated weakens, the differences in yield may evaporate or even fall below domestic yields. Currency speculation is not a game most investors should play.
• Sector mutual funds concentrate on one industry or a few closely related industries. Because they are concentrated in an industry, they are not well diversified. Beyond the additional risk, the trick to master is just which sector funds to invest in. At the top of most "best-performing mutual funds" lists will be some sector funds, but they'll also appear on the "worst-performing mutual funds" lists—it's just a question of when. Most aggressively managed stock mutual funds concentrate in some industries and might be viewed as a combination of sector funds. Few investors are willing and able to place sector bets unless they have particular experience in a sector through their education, work experience or vocation, and if they do have expertise, selecting individual stocks may be more rewarding.
• Do index mutual funds have a place in your portfolio? Yes, but they don't add to the number of funds. They simply are another way of managing your assets in one of the fund categories necessary for a rational, well-diversified, non-redundant mutual fund portfolio. Index mutual funds should be employed in a situation where even the brightest and best of portfolio managers using superior timing and stock selection decisions would have difficulty overcoming the cost advantage of an index fund. Areas of the markets that are efficient, have readily available information, are well-researched and followed closely by the investment community, or are simply not susceptible to very profitable analysis are candidates for indexing. The market for large domestic stocks and the U.S. government bond market fit the index fund criteria. Small domestic stocks and emerging foreign markets do not. These markets have attributes that make intelligent, thorough analysis more likely to contribute returns that can overcome the cost of active fund management.

Style Diversification in a Portfolio of Mutual Funds

An added classification for domestic stock funds is investment style—mutual funds can be categorized as growth or value, or both. Growth mutual funds would typically invest in stocks with high earnings growth expectations; value mutual funds would invest in stocks with low prices relative to earnings and net asset values. The style label should be based not on what the fund says it is or what it says it will do, but on what it does. Investment style classification should serve to help investors avoid redundancies and coverage gaps. But they also beg the question, "Should a portfolio of stock mutual funds be diversified by style as well as size of stocks?" Size, yes. Style, perhaps.

Many mutual funds operate in more than one stock size range and many use approaches that are classified as both growth and value. Do you need a value and growth fund in each stock size category? No. One value fund, and it might be the large stock fund, and one growth fund covering the mid-sized and small stock area provide coverage of size and style. A large stock index fund will be both growth and value, and more extensive indexes will cover value and growth for more stocks and stock size ranges.

Eight Is Enough…

Understanding the style and stock size characteristics of mutual funds will help prevent duplications and unnecessary run-up in the number of mutual funds in your portfolio. Now, back to our count of mutual funds: We left off at six with one fixed-income fund, or seven funds with two fixed-income funds. Add a money market fund and the counter clicks to eight. Be sure you can justify adding mutual funds to your portfolio beyond eight. Make certain you need them, that they truly cover new ground in asset type, geography, or investment style, and that the addition is meaningful.

Taking the time to create an organized, understandable, appropriate and efficient portfolio of mutual funds may be your most important investment.

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Dollar Cost Averaging Amid Downturn

Dollar Cost Averaging Amid Downturn

This is a big issue for many of you right now. I know you are alarmed by what is happening in the economy, and terrified by what is happening to your savings. There is a lot of talk about the "worst case scenario," which historically was the collapse of 1929-1932. During that period the Dow Jones Industrial Average fell a simply stunning 89%, from peak to trough, and did not recover all its lost ground until 1954. To put that into context, a similar fall today would take the Dow down to about 1600.

At times like these it can be incredibly difficult to stick with your long-term investment plan. Nothing like this has happened in 80 years, and even long-standing market veterans are badly shaken. Many of you have simply given up. Yes, you know the time to buy shares is when shares are cheap. You may even concede that shares are probably pretty cheap now. But who has the stomach for yet more losses? What if things get a lot worse?

Investing by dollar cost averaging can help a lot. This simply means that you put exactly the same amount of money into mutual funds or shares every month. When markets are up, you get a little less. When markets are down, you get a little more.

When you choose to dollar cost average you are giving up any attempt to time or catch the absolute bottom of the market. Most investment veterans see that as a huge plus. Few if any fortunes have been made by those who tried to catch the falling knife. Legions have been lost. Dollar cost averaging will also underperform a bull market. If shares simply skyrocket over the next twenty years, the most money will be made by those who invested all at once at the start. But that's a big gamble.

To see how dollar cost averaging might have helped an ordinary investor during the worst meltdown in history, I looked at data from the Great Depression. (My data source was Ibbotson Associates, founded by Yale professor Roger Ibbotson and now part of Morningstar.) And I looked at total shareholder returns, which includes reinvested dividends, for a basket of the top 500 companies on the market.

At the worst moment in the crash of 1929-1932, someone who dollar cost averaged had still lost about two-thirds of his or her money.

That is plenty scary. Terrifying, even. But before you bolt from your mutual funds, never to return, let me add several things.

First, these are the numbers for the unluckiest investor - the guy who began dollar cost averaging at the absolute worst moment in history, namely Sept. 3, 1929. Those who started later in the crash did at least slightly better.

Second, the performance in real terms wasn't quite as bad as it seems. That's because of deflation - the phenomenon of falling prices that helped cause the crash in the first place. A dollar in 1932 bought a lot more than a dollar in 1929: Average prices fell by about a third. So in real terms even the unluckiest investor - one who started in September 1929 - was only down, at the low point, by just over a half.

Third, they recovered fast. When the market turned, those who stuck quietly to their plan got repaid quickly. Forget that stuff about 1954. According to Ibbotson data, someone who dollar cost averaged was back on level terms by 1933. And by 1936 he had doubled his money (though the crash of 1938 then knocked him back to evens for a while).

Incidentally, while Wall Street plummeted 89% at its lows, overseas markets did not do quite so badly. They fell, overall, about two-thirds according to data from Philippe Jorion, an economics professor at University of California-Irvine. That's still bad, but it is very different from 89%.

It's an argument for sticking to regular investments through this crash: Not bailing, and not jumping in with both feet either. The simplest strategy worked; investing the same amount, every month. It's also an argument for investing globally, and not just in the U.S., which is a lot easier to do today than it was in 1929.

Oh, one more thing. Someone who started in September 1929 and invested $100 a month, every month, in Wall Street for 30 years got rewarded in the end. His total investment came to $36,000. The size of his nest egg by 1959: An extraordinary $411,000, or more than 10 times as much.

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Introduction to Asset Allocation Allocation

Introduction to Asset Allocation Allocation
Asset allocation is a snappy phrase that simply means dividing your investments among several different categories in an attempt to protect your portfolio from wild swings in any one section.

Some experts believe that asset allocation is the single most important factor in investment success.

Generally, you will want to consider a mix of stocks, bonds, and cash. The percentage you select for each investment category is the process of asset allocation.

For example, you may decide that your particular situation calls for a mix of 80 percent stocks, 15 percent bonds, and 5 percent cash. You might further break it down this way:

Stocks 80%
Income 20%
Growth 40%
Foreign 10%
Small-Cap 10%
Total: 80%

Bonds 15%
Long-Term 10%
Mid-Term 5%
Total: 15%

Cash 5%
Short-Term Bond Fund 5%
Total: 5%

These are hypothetical numbers for a hypothetical investor. You should base your particular allocation on a number of factors, including:

• Risk tolerance
• Years to retirement
• Your income
• Your savings

Splitting your assets among different investment categories helps you weather the ups and downs that are part of the investing cycle. For example, bonds and cash may add balance to your portfolio.

Investors often use the terms “diversification” and “asset allocation” interchangeably; however, asset allocation is a much more thoughtful process. Diversification means not investing solely in any one investment category. Asset allocation takes that one step further and assigns specific percentages to each category.

A general guideline is that younger investors can afford to be more aggressive because they have more time to ride out short-term drops in the market cycle. Older investors may be more comfortable with a conservative plan, particularly as they get closer to retirement. The more time you have, the better chance you have to reach your goals.

Things to Remember:

• Asset allocation is the process of splitting your investments among stocks, bonds, and cash.
• A properly balanced portfolio can help protect you from severe market fluctuations.
• Risk tolerance plays a big role in portfolio selection.

Things to Do

• Look at your portfolio at least once a quarter for proper balance – more frequently in turbulent markets.
• Examine your current holdings and figure out the percentage you have invested in each category: stocks, bonds, and cash, and ask yourself if you are comfortable with that mix.

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Past Performance is No Guarantee of Future Results

Past Performance is No Guarantee of Future Results
Famed hockey player Wayne Gretzky summed up his secret to success when he said, “go where the puck will be, not where it is.” When analyzing a company or mutual fund, many investors would do well to heed the same advice. Instead, they suffer from what is known in the business as “performance chasing”. As soon as they see a hot asset class or sector, they pull their money out of their other investments and pour it into the new object of their affection. The result is much akin to someone chasing lighting – they go where it has struck and then wonder why they continue to compound at lower than average rates of return; a tragedy that is exasperated by frictional expenses.

As the late Benjamin Graham, father of value investing, pointed out to his readers, past performance is useful in calculating the value of a stock, bond, mutual fund, or other asset only so far as it is indicative of what is to come in the future. Often, the very best time to invest in a particular area is when it has suffered from horrific industry trends over the recent past. Take the oil sector, for example. In the late 1990’s, black gold was trading at $10 a barrel and very few analysts saw an end to the energy sector’s woes. Yet, over the past six years, an investor in refiners such as Valero or an integrated giant such as Exxon Mobile have experienced wonderful returns.

How can you help ensure you aren’t guilty of jumping into a hot sector? Ask yourself the following questions.

* What makes me think the earnings of this company will be materially higher in the future than they are at the present time?

* What are the risks to my hypothesis of higher earnings? How likely is it that these theoretical risks will become actual realities?

* What were the original causes of the company’s underperformance? If it was in any way linked to aggressive accounting, what makes you sure that the situation has been permanently resolved and integrity restored to the firm? If it was an industry specific problem, what makes you think that the economics going forward will be different? A temporary supply and demand situation? Lower input costs?

* Has this particular sector, industry, or stock experienced a rapid increase in price in recent history? Knowing the principle that price is paramount, does this still make the investment attractive? Have the prospects for better earnings already been priced into the security?

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Choosing a Target-Date Mutual Fund

Choosing a Target-Date Mutual Fund

Target-date mutual funds were created more than 10 years ago and billed as a simple, one-size-fits-all investment solution. But is anything ever quite that easy? The simple answer, of course, is, “No.”

Why Own a Target-Date Mutual Fund?

If you plan to retire in 20 years, you might consider buying a target-date mutual fund that matches your time frame -- that is, a fund with a target of 20 years. As you approach your retirement date, the fund moves its allocation away from riskier, but often higher-rewarding mutual funds (with holdings like equities) to more conservative mutual fund investments (with holdings like bonds and cash). The idea is to save you from having to ensure that your portfolio is re-allocated based on your changing needs: Let the fund do all the work.

The target-date mutual fund's re-allocation over a predetermined period to reflect investors’ changing tolerances for risk is known as the target-date fund’s "glide path." This glide path sets the fund’s allocation among various asset classes over time, adjusting the mix from more aggressive investments early in the life of the target-date fund to more conservative investments as the fund matures and investors approach their target retirement date goal.
Analyzing Target-Date Mutual Fund Options

If you are counting on target-date mutual funds as a simple solution to your retirement investments, be careful. Just as with any investment, you need to do some homework first. All target-date mutual funds are not all created equal.

Funds with identical target dates may have very different asset allocations. For instance, the T. Rowe Price Retirement 2030 Fund has 66% invested in equities at the target date, while the Vanguard 2030 Retirement Fund has 50% invested in equities at the target date. While the two funds have the same target date, the asset allocation at the target date is drastically different. You need to carefully determine your comfort level with the target-date fund's current asset allocation and be aware of the fund's higher/lower equity allocation at your target date. One size does not fit all.

When looking for the right target-date mutual fund for you, consider the following:

* Asset allocation --
Look carefully at your target-date fund’s allocation between equities, bonds and cash, and examine how these holdings change as the fund moves closer to your target date and beyond. Remember that in the example described above, the allocation among various asset classes can be different from fund to fund.
* Diversification --
Does the fund predominantly invest in US stock funds or is a portion invested in international stock funds, emerging market stock funds and hard asset funds? Does the target-date fund allocate a portion of your assets to Treasury Inflation-Protected securities or does it stick with plain vanilla bond funds.
* Quality of Underlying Funds --
Look at the funds within the target-date fund. Are they mediocre, or do they have a reasonable track record when compared against their peers?
* Fund Families --
Does your target-date fund invest in funds outside of the fund's fund family? In other words, if you buy a target-date fund from Fidelity, does it only invest in Fidelity funds or does it look to other fund families to manage a portion of the fund? Often times, one fund family specializes in one particular investment style (equities for example) while another fund family may specialize in another investment sytle (bonds for example).
* Expenses --
with any investment, costs should always be a consideration. Is your target-date fund a no-load fund, or is there a front-end or back-end load associated with the fund? How does the expense ratio of the fund compare with other target-date funds? While it's never a good idea to simply purchase a fund because it has the lowest cost structure, your target-date fund's costs should be carefully weighed along with the benefits.

Unfortunately, there is not a simple solution to choosing the right target-date fund. Like any proper investment, you must do your homework by researching and understanding the asset allocation, diversification, underlying funds, and cost structure. A little research, will put you a long way toward finding the right fund for you.

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