When selecting mutual funds for your investment portfolio there is one attribute of your portfolio you should consider and that is asset allocation. Here are some ways to think of asset allocation and the various types.

Conservative Asset Allocation – This type of allocation puts you in more conservative funds for your investment style. When you decide to invest in mutual funds that make up this asset class, you’re frame of mind should be:

• You DON’T feel comfortable investing in high risk investments to possible gain higher returns than average.
• Your investment objectives for this asset allocation might include larger investments bonds and cash.
• You might not be interested in investing in stock equities.
• You’re interested in preserving capital.

Moderate Asset Allocation – This type of allocation puts you in more conservative funds for your investment style. When you decide to invest in mutual funds that make up this asset class, you’re frame of mind should be:

• You’re interested in investing in assets that have lower risk than what’s described in the aggressive asset allocation but higher than what’s described in the conservative asset allocation.
• The moderate portfolio might contain a mixture of income and capital gains investments.

Aggressive Asset Allocation – This type of allocation puts you in the most aggressive funds for your investment style. When you decide to invest in mutual funds that make up this asset class, you’re frame of mind should be:

• You feel comfortable investing in high risk investments to possible gain higher returns than average.
• You’re allowing more than 15 years to accomplish your investment objectives.
• Your investment objectives for this asset allocation might include larger investments in small company funds.
• Aggressive stock funds would also be considered for this asset allocation.

For an example list of mutual funds that make up this type of asset allocation read Aggressive Asset Allocation.

While asset allocations might include some of each other, e.g. – bonds, stocks, cash, etc, it’s the percentage of those asset classes mixed together that make up asset allocation. When coming up with the right asset allocation for you, it’s about answering questions like, “How well do you want to sleep at night?” and “How best can you protect your investments as you move closer to retirement?”.

Are you diversified? What is Diversification? In the context of this blog, diversification has to do with your portfolio. Yea but what’s a portfolio?

View a portfolio as a big empty box. We’ll put stuff in this empty box to make up our portfolio. Let’s pick one mutual fund and take a look inside. We’ll pick the Hodges Fund, symbol HDPMX.

I talked about the Hodges Fund in my What is a Mutual Fund? article. If you look at their top 25 holdings they publish every week, some of them include the following:

• Cisco (CSCO) – Telecommunications
• Union Pacific Corp (UNP) – Railroads
• ConocoPhilips (COP) – Integrated Oil & Gas
• Costco Wholesale Corp (COST) – Broadline Retailers
• Legg Mason (LM) – Investment Services

Are you seeing the diversification here – Telecommunications, Railroads, Oil & Gas, Retailers, Investment Services. You should be thinking, hey, the one mutual fund we’re talking about is diversified.

In this example, diversification is owning a bit of stocks in many different sectors or industries. So yes, the mutual fund itself is diversified and we haven’t even put it in the box yet, our portfolio. So let’s put it in our portfolio.

The more we diversify our portfolio, the more resilient our portfolio will be to the crazy market swings that we’ve been seeing lately.

The beauty of this for the small investor who doesn’t have tons of money is that the mutual fund offers instant diversification.

Diversification reduces the risk and volatility of investing directly in stocks and bonds which usually don’t move up and down in the same direction at the same time.

If one type of investment is going up and the other is going down, your portfolio or in some cases, just your mutual fund is less volatile.

Now, imagine putting an International Fund into your portfolio. How about a sprinkling of a small cap value mutual fund and a small cap growth mutual fund. Keep going with a large cap value and a large cap growth mutual funds. That’s many levels of diversification within your portfolio.

Here are The Five Core Asset Classes Every Portfolio Should Have:

1. Large Growth – Large Company Growth
2. Large Value – Large Company Value
3. Small Growth – Small Company Growth
4. Small Value – Small Company Value
5. International

In addition to that you might add some of the following depending on your investment goals:

• Bond Funds
• Balanced Funds
• Sector Funds

To describe an Index Fund I’ll use the classic Vanguard 500 Index fund, symbol VFINX.

The VFINX fund is made up of stock in the 500 companies that the S&P 500 tracks. You would own a piece of all the 500 companies in the S&P 500.

The S&P stands for Standard and Poor’s. Standard and Poor’s is the leading provider of financial market information.

The S&P 500 is a leading benchmark for how the markets are doing. Many funds are compared to the S&P 500 performance. The 500 companies performance.

So if we take a look at the chart from Morningstar below, we can see that red, orange and green lines are stacked on top of one another. How in the heck can you see that if they’re stacked on one another!! Well, trust me.

The red line indicates the VFINX fund and its performance. The orange line indicates the category’s performance that the VFINX is in and the green line indicates the S&P 500 and its performance.

This is a great fund that a lot of folks invest in and it resembles the latest talk amongst those folks who want to make their lives simple by investing in index funds.

Some reasons include:

• The VFINX tracks the market, and we’ve been told that historically the market goes up. So if a person can hold the VFINX fund in their portfolio or as their only holding in their portfolio, and if they can stomach the downs of the market that we’ve been experiencing lately, then that is the promise. This fund will go up with the market and go down with the market. It will never do better than the market. In other words, it will NOT beat the market when the market goes up and it won’t try and lose less than the market when the market goes down. WOW!! What a mouth full.
• The expenses related to the VFINX are extremely low. The fund manager basically doesn’t have to do too much. At Morningstar it’s listed as 0.18%. We’ll talk through the “Express Ratio” in another post. But that is one indicator to look at that will tell you how much it costs to run a fund and the VFINX is good and low.
• The VFINX is considered tax efficient. Why? Because the fund manager doesn’t have to trade in and out of different investments that would cause a taxable event like selling a stock. There would be very little selling since the “makeup” of the fund doesn’t change often.

There is great power and trouble-free worry when it comes to owning the Vanguard 500 Index fund. Through the power of compounding over a long period of time this fund would do good for a lot of folks.

Of course, according to Morningstar it would cost you a minimum of $3,000.00 to get into this fund.

If it’s available to you in your employer’s retirement plan, you would most likely be able to get into this fund without the minimum. Check with your employer.

If you’re interested in holding the VFINX in your Roth IRA, you’re brokerage firm will list the minimum to get into this fund.

Disclaimer: Past performance is not a guarantee for future performance. Even owning this fund you are taking a bit of risk. The risk of the market.

So what is a Mutual Fund anyway? There are many ways to answer this question but here are a few definitions from some excellent sources:

“A mutual fund is a form of collective investments that pools money from many investors and invests their money in stocks, bonds, short-term money market instruments, and/or other securities. In a mutual fund, the fund manager who is also known as the portfolio manager, trades the fund’s underlying securities, realizing capital gains or losses, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. The value of a share of the mutual fund, known as the net asset value per share (NAV), is calculated daily based on the total value of the fund divided by the number of shares currently issued and outstanding.” Source

“A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, or other securities.” Source

“…For them, the financial industry invested mutual funds – pools of stocks or bonds that are managed by professional investors.” Source

“…A mutual fund brings together people, too–people who want to invest. The fund pools together the group’s money and invests it for them in a collection of securities, such as stocks or bonds or a combination of the two.” Source

“A mutual fund is nothing more than a collection of stocks and/or bonds. You can think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the holdings of the fund.” Source

“A mutual fund pools money from hundreds and thousands of investors to construct a portfolio of stocks, bonds, real estate, or other securities, according to its charter. Each investor in the fund gets a slice of the total pie.” Source

Hopefully by now you know what a mutual fund is. To put it simply – a mutual fund is a  basket of investment vehicles including stocks, bonds and other securities.

Have a look at the Hodges Fund (symbol: HDPMX). This is a fund that is categorized as a Mid-Cap Blend fund by Morningstar. Their website lists the funds top 25 weekly holdings. So for definition purposes, the stocks listed are considered the investment vehicles, and the stocks are in a mutual fund called the Hodges Fund, symbol: HDPMX.

You can visit Morningstar, MSN Money, Yahoo Finance, and Google Finance to view other mutual funds and their holdings. Just find the ticker symbol, for example HDPMX to look up funds you’re interested in.

Mutual Fund Management

Mutual Funds are managed by one manager who makes the day-to-day decisions.  The fund could also be managed by a team of people. One school of thought is that it’s better when one person is making the buy and sell decisions to better track the fund manager’s performance.  With a team of people making the decisions, an investor might not know who is on the team and who is making the decisions that will affect the fund’s performance.

While it’s important to know what stocks are in a mutual fund, don’t get too caught up in what’s in the fund today because tomorrow there could be stocks that the mutual fund manager bought and sold.

In the mutual fund industry, a fund’s past performance won’t guarantee future success. Just like a great baseball pitcher or batter, your odds of success go up when you are in a fund with a mutual fund manager who has a great track record.

Types of Mutual Funds

Stock Mutual Funds – Also known as “equity funds”, are mutual funds that invest only in stocks. They are considered more risky. However, sometimes with greater risk comes greater reward. Over long periods of time, stocks have outperformed both bonds and cash investments.  Depending on a person’s risk tolerance, owning stock mutual funds would be a good investment for people under the age of 50 who can tolerate a bit of higher risk and have a longer investing time horizon before retirement.

Bond Mutual Funds – Bond funds invest in bonds and other debt securities. These make them more conservative investments that aim to protect your investment money. You typically choose bond funds for income and diversification. Bond funds are considered “low risk”. Again, depending on your risk tolerance, some investment advisers recommend owning 50% bond funds when you turn 50 years old and adjust accordingly as you get older by decade.  In other words, at age 60, you might own 60% bond funds.  This is just one way to invest in bond mutual funds.

I’ll save other types of funds for another article, but the stock and bond funds are two biggies.

My Secret

Let me share with you, that over 25 years ago, I had no idea what a mutual fund was or what a stock was. After searching far and wide on how to invest in stocks, making my own stock selections, etc., I discovered mutual funds, and felt a great relief as I could invest in stocks without having to make the day-to-day buy, sell or hold decisions, and that there were folks out there called mutual fund managers who would do that for me.

If you are new to mutual funds and want more mutual fund analysis, recommendations and information on what to look for in mutual funds, consider bookmarking this site for future mutual fund news.

When you sign up for your employer’s retirement plan and it allows you to select mutual funds, you could be presented with a laundry list of mutual funds or a very limited choice of mutual funds.

So what do we do? We ask friends and possibly relatives for advice and go to Smart Saving and Investing to get some help. Then we question our choices, ask our co-workers what we should do and just close our eyes and pick something.

Well, that’s the way I did years ago when I first started out investing in my employer’s retirement plan. No one really knew what to do. There was no Internet around to help do research. You could read trade magazines until your eyes turned red and you still didn’t know or understand what the heck to make of it all.

On top of that your co-worker ended up day-trading in and out of their mutual funds based on the economic news of the day, which is the worst thing you could possibly do and there are now provisions in place to help stifle that type of trading behavior.

So here we are today with a whole gamut of websites, blogs and every type of media to help figure things outs…or still continue to confuse the same person starting out in mutual funds under their employer’s retirement plan.

Well, I’ve narrowed it down to using a couple sites, namely Morningstar (a very well trusted site on financial data and news) as well as Fund Alarm. Fund Alarm allows you to look at a fund by typing in the symbols of the fund, let’s say FMAGX for Fidelity Magellan and quickly find out if it’s considered one of their “3-Alarm” funds.

At Fund Alarm, a “3-Alarm” fund can be considered a sell this fund immediately or do not buy decision. Here is a screen shot of Fidelity Magellan from Fund Alarm.

Notice the areas I circled. You can instantly tell that Fund Alarm considers this a “3-Alarm” fund. Here is their link that helps you determine if you should sell this fund or not. The second, bigger red circle displays the fact that the fund has underperformed its benchmark the Vanguard 500 Index for the last 12 months, last 3 years, and last 5 years. Which is not good. You want to match or handily beat the benchmarks used to compare your funds.

So unfortunately I would have to say don’t buy Fidelity Magellan at this time and if you’re currently holding it, get rid of it first thing in the morning!!

Now, let’s take a look at a fund and use Morningstar and Fund Alarm together to do some quick research and decision making. Our choice today is PRGFX – The T. Rowe Price Growth Stock fund. This fund falls into the Large Growth category.

From previous posts you might remember I favor this asset allocation for 2007:

• Large Growth – 35%
• Large Value – 20%
• Small Growth – 20%
• Small Value – 15%
• International – 10%

The selection of funds where someone chose PRGFX was a company that only offered employees 20 different funds to get into so it can be tough when you don’t have a bunch of choices.

So let’s take a look at PRGFX at Fund Alarm:

Now this one looks very good at Fund Alarm. You can use this link at Fund Alarm to read about “How to Read the Fund Alarm Data Table.” It tells us that it’s a “NO-ALARM” fund and has beaten its benchmark (the Vanguard 500 Index) for the last 12 months, last 3 years and last 5 years. That looks very good and it would be one that I’d pick for the selections that were allowed at this employer.

Here’s the “Snapshot” page from Morningstar:

You can see the red line on the chart shows us that funds performance for the last 5 years…almost, because 2007 isn’t over yet. So with Morningstar they like to compare a lot of funds to the S&P 500 as its benchmark. Also, the data at Morningstar is more up to date than the Fund Alarm site. If you look closely at the date of the data reported on PRGFX at Fund Alarm you see “Data as of 5/31/07″. Morningstar is reporting as of 6/30/07.

Notice the Fund YTD (Year-To-Date), 3 year and 5 year under the Morningstar chart. This is the percentage (12.05, 15.01 and 14.96 respectively) of return on the hypothetical $10,000.00 that Morningstar likes to use over those time periods. Under those figures are the positive numbers that indicate how much the fund beat its benchmark during those times. Again, Morningstar is using the S&P 500 as the benchmark in this case.

Well, hopefully you’re not completely confused and there are lot of terms to think about and discover. I only presented a portion of the Fund Alarm site and Morningstar site. You can get into much more detail at the Morningstar site.

I hope this article presented some useful data and techniques to use when evaluating the mutual funds in your life. Let me know if you have any comments or questions and we’ll get them answered together.

If you want to make this process extremely easy then browse over to Smart 401k and pay for them to select your funds for you if you can afford to. Smart 401k you’ll answer a short questionnaire so they can determine what type of an investor you are and then they’ll email you the recommendations based on your fund choices and what type of investor you are as far as risk is concerned.

When you have a big fund it’s harder for the fund manager to maneuver. For example, a pretty darn good fund in the Fidelity family of funds is the Contrafund. However, it’s become rather large at greater than 70 billion dollars in assets.

So, the fund becomes representative of the market. If the market goes up, most likely the fund will go up and if the market goes down, most likely the fund will go down.  The fund’s manager has to get creative to move those types of dollars around.

It’s like parking semi-trucks in a fast food restaurant. So what to do? Well, I still think if you don’t have other choices, the Fidelity Contrafund is still a great fund with a great fund manager. I would hold it in a company retirement plan like a 401k, 403b, 457 Plans.

But, there are smaller funds in this category of Large Company Growth funds that are more agile. It would be good to find a fund with a great fund manager that is managing say 1 or 2 billion dollars worth of assets.

So one example would be the Brandywine Blue (BLUEX) fund. It has more than 2 billion dollars in managed assets and the fund manager William F. D’Alonzo would have more strategies to implement with the investments in the fund.  However, the initial investment to get into this fund would be a whopping $10,000.00 but there is no load (fee) to get in, during or out of the fund.

So for some folks this is just an example and not what you should do with your money.

When I started contributing to my employer’s retirement plan there were a few fund companies with quite a few funds to pick from. At the time there was an excellent book out by Peter Lynch called “Beating The Street”.

Peter Lynch managed the Fidelity Magellan mutual fund until 1990 and returned huge gains. His successors did pretty good for a few years and then it was time to dump Fidelity Magellan sometime in the ’90s. But there were a ton of folks who kept it for a long time just because of the name. Hoping it would have that ounce of magic left to make a big return.

I know folks are still in it and maybe don’t even know what return they’re making from it nor do they possibly care.  It’s as if some people use their employer’s retirement plan as a forced savings account and don’t know what kind of return they are getting or what kind of return they should be getting.

So, if you’re in Fidelity Magellan you should get out.  With all the funds to pick from and hopefully you have more choices to pick from your employer’s retirement plan, try and get on the right track with at least a fund that tracks the S&P 500.

One way to compare your fund to others and its performance is to do some research at www.fundalarm.com.  You can also post your funds here or the choices you might have and we can give an opinion as well.

Or you can try the paid service at www.smart401k.com to get some professionals to help you with your choices.

Here are some rules guidelines to follow when investing in mutual funds:

• Invest in no-load funds that will beat the index funds in good times and won’t lose as much in the bad times.
• Index funds are ok. Index funds will do what the market does. You will make what the market makes and you will also lose what the market loses. However, that is certainly ok in a conservative kind of way.
• No fund company has a lock on all the best funds. For example, Fidelity does not have all the best funds. So you’re probably not going to buy four mutual funds from Fidelity.
• Find the best managers of these funds by looking at their track record and not the name of the fund. Don’t follow the fund name, follow the fund manager.
• Look for funds where the manager is making the day to day decisions and not a team of people. Good and bad people come and go on teams and you might not know it when it happens or who is making the decisions.
• Whenever a fund under performs for 12 months but it has proven itself over the 3, 5 and 10 year time horizon, then it’s time to start watching that fund closely and making a decision within the following 12 months.
• Use the S&P 500 to compare your mutual fund performance to.
• Use the EIFA Index to compare international funds to.
• Review your mutual fund(s) every six months or quarterly.