Mixing Your Mutual Funds
Modern Portfolio Theory (MPT)
Modern Portfolio Theory is the opposite of traditional stock picking as economists try to understand the market as a whole, rather than business analysts who look for what makes each investment opportunity unique. Investments are described in terms of their expected long-term return rate and their expected short-term volatility. The goal is to identify your acceptable level of risk tolerance and then to find a portfolio with the maximum expected return for that level of risk. Those who believe in MPT say that basic asset allocation accounts for 90% of the reason behind investment return.
Basic Asset Categories
When developing the right mix, the first place to start is with the three basic asset categories - stocks, bonds and cash. Each asset category has a basic level of risk with an expected return.
- Bonds will typically provide higher returns than money markets but can also be a little more volatile. If you go back as far as 1924, bonds have provided an average return of about 6.4% The bond category can also be broken down into short term bonds, mid term bonds and long term bonds.
- Stocks carry a high level of risk. However, given time, they also provide the highest returns. In fact, the average return since 1924 for most equities has been 10%.
Modern portfolio theory states that by mixing these three basic asset categories you can optimize your level of risk and return.
Adding other variables to the mix
With your asset allocation decision made, you can turn your attention to other portfolio management issues highlighted below:
- Geography. In any single year, the US markets are not always the best performer. Adding geography to your portfolio means that you want to diversify your holding around the world. International funds are an excellent way to increase your geographic diversification.
- Capitalization. The stock market is generally broken down into three different sizes of companies. Generally speaking, the breakdown of market capitalization categories are:
- Large cap. = $10 billion to $200 billion
- Medium cap. = $2 billion to $10 billion
- Small cap. = $300 million to $2 billion
- Sector Breakdown. Stock markets are not only categorized by their geography and capitalization but also by sector. The stock market consists of different sectors like technology, resources, financial services, health sciences, etc. Every sector goes in and out of favor so having different sectors in your portfolio is a very important aspect of risk management.
- Management Style. Mutual funds have two main types of styles: value and growth. Different styles will also go in and out of favor. As with sectors, a well-diversified portfolio will have exposure to both styles.