Three steps to building a mutual fund portfolio

Most investors are searching for answers, explanations, and reasons why their mutual fund portfolios are taking such a beating. Many have questioned how to build and manage a mutual fund portfolio. I would like to walk you through some important steps and issues to building a proper mutual fund portfolio.

Portfolio construction can be broken down into three very basic steps:

  1. First, take the time to understand what you are looking for. Risk tolerance, time horizon, financial objectives, past experience, and retirement needs are all examples of issues you need to understand to build the right portfolio. This step is necessary to personalize the portfolio to the needs of the individual investor. Billy is 65, conservative and fairly well to do. He has $500,000 in investable assets. He is retired with a pension that he can live off of. He does not need nor wants to take risks. He also understands that low-risk investments do not have great returns. Billy understands investing as he has handled the money for his entire life. Sara is a 42-year-old divorced mother of two. She has about $115,000 in investable assets but no pension. She needs to make sure these investments grow to provide for her in retirement. She has about 20 years to accumulate funds. She does not like a risk but understands that she needs to take some risk to get better returns.Given this brief background, Billy and Sara would likely have very different portfolios.
  2. Next, you must develop an investment mix. I often relate to mixing investments to making fruit salad. The first thing you need to determine when making a fruit salad is to decide what kinds of fruits to use. For example, say I like apples, oranges, and strawberries. This would be very different than my wife, who likes watermelons, cantaloupe and honeydew. From an investment perspective, you must understand some basic investment categories to choose from:
    • Asset Class – how much should you have in stocks, bonds, and cash?
    • Geography – Where in the world should you invest (US, Japan, Canada, Europe, Asia)?
    • Investment Style – How is the mutual fund managed (Value, growth, momentum, GARP, top-down)?
    • Sector – Are the funds sector-specific (resources, technology, financials, health care, consumer goods)?

    Remember, these investment categories will move in different directions at different times and a well-diversified portfolio means you are likely to have at least one underperforming asset class at all times. This is the principle of proper diversification.

  3. The last step is to select the investments that fit those categories. If we go back to the fruit salad analogy and decide you want apples, you must go to the supermarket and select two or three apples for your fruit salad. Typically, most people would look at color, price, and size. Through the process of elimination, you will come up with a few apples that meet your criteria. When it comes time to selecting mutual funds to fit into your mix, you will need to define some criteria and standards about performance, risk, fees, taxation, consistency, just to name a few. Everyone will have their own set of standards as to what they might be looking for.

Review the process

The most common mistake made by investors is they put the most emphasis on step number three. In fact, the tendency is to start at step number three. The problem with this thinking is that if you start at step number three, you will rarely make it to steps one and two. Yet, these are arguably the most important steps. It has been argued through modern portfolio theory that step two, the mix, accounts for over 90% of your investment return and step three, accounts for less than 10%. Yet 90% of the time, investors are on the search for the best investment instead of the best mix.

Let me walk you through two examples of this. When technology was going up, it mattered less about which technology fund you bought. They all made lots of money. Rather, the important step to making money was to ensure that you have some exposure to technology. On the other hand, over the last 10 years, chances are if you picked the best Japanese Equity fund, you still did not make a lot of money. Why? Japan has been less than the stellar market over the last 10 years.

So if you are reviewing your mutual fund portfolio, make sure you take the time to walk through all three essential steps to portfolio design

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