Intelligent allocation of assets, proper diversification, and the right choices of suitable funds. Those are just a few of the basic aims investors should have for a portfolio composed of mutual funds. It doesn’t matter whether the investor is nearing the point of withdrawal from the fund or is continuing to build it up, the goals remain the same for people who want a successful fund.
Anyone can experience problems along the way to the desired endpoint. The following points look at three obstacles that are frequent problems for investors and discuss tactics for success.
Table of Contents
1. Not Having a Strategy
Operating without a strategy is the most typical problem of all. I’m never surprised by how many people choose their mutual funds without even considering a technique for allocating the fund’s assets.
Of course, numerous investors do take the time to identify and spell out their investing goals, but subsequently gloss over the next critical task for developing a profitable portfolio of mutual funds: composing a specific approach for allocating assets.
In the absence of a plan that meets their particular aims and desires (like timelines, rate-of-return, total risk, etc.), the fund ends up being assembled in a random way instead of a well-thought-out one.
In nearly every such case, randomized choice of funds leads to poor allocation of assets and not enough diversification. The end result is a portfolio that provides weak overall performance.
When diversification is lacking, the portfolio is inevitably one that suffers from an unsuitable risk-reward profile as well as inadequate allocation.
Funds whose categories are not weighted correctly or that contain assets that shouldn’t be included at all are one example. Poor weighting means allocations that are out of kilter in terms of percentages, primarily representing either too large or too small a percentage of the total fund.
Inappropriate selections of funds are a more obvious problem. They are simply a case of funds that should not be a part of the portfolio, based on its general objectives.
On the other hand, smart diversification comes from making a specific plan about how to allocate assets based on personal preferences and other investment goals. Wise diversification results in lower risk by making sure that fund assets represent numerous asset categories.
Taking the time to develop a specific asset allocation plan help avoid over and under-weighting, inclusion of the wrong kinds of assets, and getting fund category percentages wrong.
Indeed, the most efficient blueprint for optimizing selection of funds is a detailed listing of how assets are to be allocated within the fund.
There are three parts to building a profitable portfolio that consists of mutual funds:
- One: Identifying the goals and preferences of your investments, namely the total value of the portfolio, its intended return, the time-line, and the total amount of acceptable risk
- Two: Developing a specific approach for allocating assets based on the type of funds and keeping the objectives in mind
- Three: Selecting the right funds for each category
Number two is the most difficult because there are so many approaches to asset allocation.
Most techniques are either stock-bond based, adjusting risk based on the percentage of each of those asset classes, or “category” funds, where risk levels are assigned to each of the equity or bond funds within the entire portfolio.
To learn more about this point, see The Role of Risk in Mutual Fund Strategies.
No matter which technique someone prefers, the main point is obvious: to avoid the common problems associated with random, unplanned selection of funds, create a specific approach for allocating assets that reflects your investing goals and wishes.
2. Holding Too Many Non-Diversified, High-Risk Funds
This is a common error relating to imbalance: having too many assets that carry higher-than-acceptable risk profiles. Note that this problem can still be present even when the types of funds included in the portfolio are correctly assigned based on stated goals.
The resulting volatility is harmful to overall portfolio returns. It’s a case of expected reward not justifying the amount of risk taken.
No matter the acceptable level of risk, over-weighting can pose a financial hazard. However, this problem, too many risky funds in the portfolio, is more common in situations where investors have high tolerance for risky assets.
Just like you should not only own mutual funds, you should definitely not only own non-diversified mutual funds.
What are some of the most common kinds of non-diversified funds that are also in the higher-than-normal risk category?
They include emerging market bond funds, high-yield bond funds, small-cap equity growth funds (both foreign and domestic), emerging market equity funds, sector equity funds, and others.
Keep in mind that those types of funds might be suitable for some investors as long as there is enough overall diversification, low risk, and a wide array of fund types within the portfolio.
What is the ideal amount of non-diversified, higher-than-normal risk funds that should be in a given portfolio? In general, the answer depends on factors like total risk tolerance, growth objectives, and income goals.
Between 5 and 30 percent is a benchmark percentage. It’s important to view non-diversified, riskier mutual funds as acceptable as long as they do not boost total portfolio risk.
3. Redundant Categories Within Funds
This situation occurs when there is not enough diversification and investors maintain more than one fund with strikingly similar goals. For example, having two growth funds composed of small-cap assets, a pair of large-cap funds as well as an intermediate bond fund made up of corporate instruments.
If you have a portfolio with just those five funds, there’s not enough diversification because of duplicate goals. Likewise, there’s a lack of risk-reward variety for proper diversification. A smarter strategy is to only hold one fund from each category.
There’s one general way to avoid the typical errors listed above: an asset allocation strategy that is detailed enough to deliver the right amount of portfolio diversification and targeted fund selection. That one rule is the core component of a plan for building a profitable portfolio of mutual funds.