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Investing in mutual funds? Some golden tips

April 08, 2009 12:07 IST

Don't let stars get in your eyes. Mutual fund companies try and dazzle you with their hottest star-rated funds, each with mouth-watering returns that will excite you. "Pick our funds! Act now! Buy this hot fund of the week!"

But, slow down. Research shows that 90 per cent of your portfolio's returns are determined by your asset allocations. And only less than 10 per cent of your returns are tied to your fund-picking skills. In short, if you start with the right asset allocations -- the ones that best fit your goals and needs -- you could almost pick the right funds by throwing darts.

Remember: You're building a winning portfolio, not just randomly picking the hot funds of the week.

Do you have the right asset allocations?

What are your asset allocations? Do you even know? Have you reviewed them lately? Do you know what asset allocation means?

If you're like most investors, your first instinct is to pick funds. But that's the wrong approach; you should take care of the fundamentals first. Picking funds, after all, is a slam-dunk - if you first take the time to structure your portfolio.

Here's how Money magazine put it in a February 1996 article by Eric Schurenberg: "In a celebrated 1991 study, researchers Gary Brinson, Brian Singer, and Gilbert Beebower statistically proved what 90 percent of investing is. It is asset allocation - the way you divide your money among the investment options."

"The researchers found that the investment mix account­ed for 91.5 per cent of the variation in total return among the investors they surveyed. Security selection (whether the investor chose stocks or bonds that did better or worse than the pack) and market timing (when an investor decided to buy and sell) together explained a measly 6.4 per cent of the difference in returns."

The bottom line: You need to plan your asset alloca­tions very carefully. You can make a lot of mistakes decid­ing whether to pick this or that fund, and it won't matter as much as the mistakes you make if your asset alloca­tions are wrong for you.

Model asset allocations

Working out a right asset allocation isn't that difficult. We've all seen most of the key variations of these asset allocation models over the years. Most of the major mutual fund families and the major brokerage firms offer them.

Unfortunately, though understandably, fund families and brokers tend to be biased. Their own interests naturally come first. Like many investors, I am inherently skeptical of their mate­rials.

The five model asset allocation profiles listed below are a best-of-the-best consensus developed using all the research that went into the model portfolios I've seen on-line, drawing on ideas from the managers with America's top twenty-five fund families, and the best brokerage firms, plus the best ideas from the editors working with America's top financial periodicals.

                                   Choosing the right asset allocation model

Here are the two most important factors in choosing your portfolio's asset allocations:

Timing/distance to target. How soon will you need the money?

Risk tolerance. How willing are you to risk losses?

You don't have to be a rocket scientist to grasp this principle of flexibility: if you have a lot of time and/or you are willing to accept higher downside risks in order to make higher upside returns, then you'll invest more in stocks than bonds and money-market instru­ments.

However, if you need the money soon and you want to protect, your capital from losses, you'll forego a shot at the highest possible returns for downside safety. And your investments will definitely lean more toward fixed-income and money-market funds.

They are designed to help you move from the world of hypothetical models to build a real-world portfolio that fits your needs. You can choose from among the following five model portfolios: 

  • Income preservation
  • Conservative income
  • Growth and income
  • Wealth builder
  • Aggressive growth

Let's look at the characteristics of all five of these portfolio types.

Winning portfolio #1: Income preservation

The 'Income preservation' portfolio is designed for investors with fairly immediate financial needs, usually less than two years, and/or those with a very low toler­ance for market risk and volatility. Such a portfolio relies heavily on bonds, hybrid funds, and money-market funds. Stock funds that fit this model would most likely be solid blue-chip growth funds.

Winning portfolio #2: Conservative income

The 'Conservative income' portfolio is also designed for investors who require a steady income flow. However, these investors also want some growth and capital appre­ciation. Since such investors have at least two to four years before they need the money, they're willing to take some modest risks, although probably few.

Winning portfolio #3: Growth and income

This 'Growth and income' portfolio is structured for investors who want capital appreciation and don't need immediate income from their portfolio. Their tolerance for risk is moderate. With a medium-term time horizon of four to seven years � more than one average bull/bear market cycle - these investors are willing to ride out near-term market fluctuations in search of reasonably solid growth and capital appreciation.

Winning portfolio #4: Wealth builder

The 'Wealth builder' portfolio is designed for long­-term investors seeking strong growth and appreciation in their portfolios. Because the time horizon of these investors is at least ten years, they are more interested in building future wealth than in current income. Returns are systematically reinvested.

Winning portfolio #5: Aggressive growth

The 'Aggressive growth' portfolio is designed for investors with a long-term horizon (more than a de­cade), plus patience and a strong tolerance for short­-term risks and market fluctuations. Current income is not important.

Now we need to connect the portfolio you may select from among the five model portfolios listed above with actual funds. But before moving on, let's review the key fact we outlined earlier, namely that in the long run:

  • Over 90 per cent of your portfolio's return is a direct result of your asset allocations, and 
  • Less than 10 per cent depends on the specific funds you pick. So you can win by throwing darts at your asset allo­cations.

Moreover, note that the research underlying this asset allocation conclusion is based on picking funds from all the funds available - including the low performers - not just from a "best funds" list in a magazine, and not one limited to a research agency's 5-star list, etc.

So, your odds of success improve substantially once you narrow the list of funds you're considering to an elite list of the very best.

That's when the Dart-Throwing Strategy starts making sense; mutual fund investing begins to become a no­-brainer because more than 95 per cent of your screening is done for you by experts who sift through all funds and isolate the best 50 or 100. All the dogs are elimi­nated and you're simply picking from a list of known performers.

So, first determine your asset allocations, and then begin to build a winning portfolio. Stay away from hot stocks and stick with the long-term performers that fit within your asset allocation needs.

(Excerpt from The Winning Portfolio: How to Choose the Best Mutual Funds by Paul Farrell, published by Vision Books.)

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