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EDITOR'S NOTE: This article is from Kiplinger's Mutual Funds 2008 special issue. Order your copy today.
The most important decision you'll make as an investor isn't which fund to buy. More vital to your long-term financial success is how you split money among different types of stocks and bonds. This asset selection will have the most effect on the two things you want to control most in your portfolio: the total return and the level of volatility. A smart, well-diversified portfolio gets you both a good return and low volatility. It's the financial equivalent of having your cake and eating it, too.
It's true that, for example, some small-company stock mutual funds are better than others. But when small-company stocks rally, all small-company funds tend to be swept along for the ride. And when it comes to volatility, studies have shown that simply spreading your money over different types of assets—not market timing or picking individual stocks -- accounts for 90% of reduced risk in a portfolio.
Think of how you will spread your money among different types of stock funds "as assembling a baseball team with players of different talents," says Michael Branham, a financial planner in Edina, Minn. "Just as you need a center fielder and a shortstop, you need different types of stock funds, which shine at different times."
Once you're set on a plan for a diversified portfolio, then you can worry about selecting the best funds in each category. We've taken that worry away from you by suggesting portfolios using our favorite mutual funds -- those in our Kiplinger 25 list.
This article will explain a little about different types of investments, and then give you three model portfolios you can adopt for your own. Each is intended for a different time horizon and tolerance for risk.
Stocks versus bonds
History does provide us with some guidance: Over the long haul, it's clear that stocks provide the best returns. Since 1926, stocks have returned an annualized 10%, according to Ibbotson Associates, a Chicago investment research firm. Over that time, bonds returned an annualized 5%, and cash, just 4%.
In the long term -- long term being key -- stocks aren't as risky as you might think. Over rolling ten-year periods, including the Great Depression, stocks have never lost more than an annualized 1%. And over rolling 20-year periods, stocks have never lost money.
The flip side of that equation is that stocks behave erratically in the short term. In their worst year since 1926, stocks fell 43% (1931); in their best year (1933), they gained 54%.
As you decide on your stock breakdown, take into account your feelings about losing money. If you break out in a sweat with each market dip, you may need to trim your stock holdings and add bonds or even cash. Successful investors need the fortitude to sustain a temporary market loss of 30% or more without bailing out at the bottom.
Your personal goals
Just as important as your personal tolerance for risk and volatility is your time horizon. If you're in your thirties, forties or early fifties and you're investing for retirement at age 66 or 67, you can justify investing virtually all of your money in a diversified portfolio of stocks. Ditto if you're investing for your toddler's college education.
But as you get closer to needing your money, the volatility of stocks demands that you invest more cautiously—which means increasing the percentage of bonds or cash. "Bonds serve as a sort of psychological safeguard," says P.J. DiNuzzo, a financial adviser in Beaver, Pa. "The number-one reason you want them in your portfolio is to lower risk and volatility." But you shouldn't abandon stocks, even if you're several years into retirement. DiNuzzo recommends keeping at least a third of your investments in stock funds well into your seventies. "You don't want to pull all of your potential growth off the table," he says.
Why diversify?
Once you've decided how much to invest in stocks and bonds, determine how you'll spread your money among different types of stock funds. History proves that different types of stocks take turns leading the market -- some go out of favor or go gangbusters for years at a time.
Shifts in style are largely unpredictable, so you won't have steady growth if you invest in only one style. Given that over long periods of time, small-company stocks provide greater returns than large-company stocks, you'll want at least one fund that invests in the little guys.
POSTED BY: stefan (February 22, 2008 05:00 AM)
Thanks for giving us your Mutual Fund picks for the selected periods - Why not give us a sampling of ETF's that would mirror those funds as well ?
POSTED BY: Krazy Kowboy (April 03, 2008 05:45 PM)
Great suggestions in the article...I've built a portfolio of Vanguard funds that represent growth, value, large and small cap, both domestic and international stocks...
POSTED BY: Gil (April 22, 2008 02:37 PM)
In response to post by Guido - That's the way I have been investing for 7 years. One fund - 10 most productive funds from that family - tweak every quarter with the 10 top producting funds.My current holdings from Phoenix Wealth Management Aberdeen International - Alger small cap growth [ Fidelity contrafunc = Fidelity grown oppor - Fidelity growth - Pimco commoddity real - Phoenix mid cap growth - Sentinel mid cap growth - Templeton Dev mkt and Wanger international select. My top 10 funds tweaked every quarter in 2007 gave me an average return of 26% for the year. Not the best but OK
