DCSIMG
Menu
 

Trust Services

Three Essential 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. Let’s go through some important steps and issues to building a proper mutual fund portfolio.

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

Step 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.

Bill 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 want to take risks. He also understands that low risk investments do not have great returns. Bill understands investing as he had 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 risk but understands that she needs to take some risk to get better returns.

Given this brief background, Bill and Sara would likely have very different portfolios.

Step 2. Next, you must develop an investment mix. I often relate mixing investment to making a 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 from my wife, who likes watermelons, cantaloupe and honeydew.

A. Asset Class - how much should you have in stocks, bonds, and cash?
B. Geography - Where in the world should you invest (US, Japan, Canada, Europe and/or Asia)?
C. Investment Style - How is the mutual fund managed (Value, growth, etc)?
D. Sector - Are the funds sector specific (resources, technology, financials, health care or 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 under performing asset class at all times. This is the principle of proper diversification.

Step 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 select mutual funds to fit into your mix, you will need to determine some criteria and standards about performance, risk, fees, taxation, and 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 three, you will rarely make it to steps one and two. Yet, these are perhaps 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.

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.

 

« Return to Mutual Fund Basics

 

First Commonwealth Advisors is a registered trademark used to market various wealth management products and services. Investment management, trust and fiduciary services are provided by First Commonwealth Bank. Certain insurance products are offered through First Commonwealth Insurance Agency, a licensed insurance affiliate. Securities, insurance products and advisory services are offered through Essex National Securities LLC, member FINRA/SIPC and an SEC registered investment advisor. Essex is not affiliated with First Commonwealth Bank.