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Three Common Mistakes in Mutual Fund Investing

by

Jack Piazza
Sensible Investment Strategies

Appropriate asset allocation...effective diversification...suitable fund selections. These are some of the fundamental goals that every investor should desire in a mutual fund portfolio. Whether an investor is in one of the various stages of asset accumulation or in asset withdrawal, these goals are necessary for mutual fund portfolios to be successful. However, an investor can encounter many roadblocks or pitfalls in the quest to attain these goals. The remainder of this article examines three of the most common obstacles and offers suggestions on how to avoid them.

 No Strategy 

This is probably the most frequent mistake in mutual fund investing. I never cease to be surprised by the vast number of individuals who select specific mutual funds without giving any thought to an asset allocation strategy. Many investors may actually define and identify their investment objectives, but then skip the next vital step in establishing a successful mutual fund portfolio: creating a detailed asset allocation strategy. Without a well-defined, appropriate asset allocation strategy that accurately reflects individual investment objectives and preferences (time horizon, return objectives, risk tolerance, etc), the selection of mutual funds is haphazard instead of a logical, clear-cut process.

With very few exceptions, the outcome of haphazard fund selection is inappropriate asset allocation, which in turn causes ineffective diversification -- with the final result being poor or mediocre portfolio performance. Ineffective diversification has both allocation and risk/reward characteristics which do not accurately represent the chosen investment objectives in a given portfolio. Specifically, these characteristics may include over-weighting of fund categories, under-weighting of fund categories and/or inappropriate funds in the portfolio. Over-weighting and under-weighting of fund categories are significant percentage imbalances in allocation -- respectively, they account for too much and too little of a portfolio's assets. Inappropriate funds do not fit the chosen investment objectives -- they are the "wrong" funds for a portfolio rather than allocation imbalances.

Conversely, effective diversification is a direct result of an appropriate detailed asset allocation strategy that fits individual investment objectives and preferences. Effective diversification spreads investment assets among different fund categories to achieve both a variety of distinct risk/reward objectives and a reduction in overall risk. Appropriate detailed asset allocation not only eliminates undesirable characteristics of over-weighting, under-weighting and inappropriate funds, it accurately matches fund categories and their percentage of portfolio assets to specified objectives -- in essence, it is the "blueprint" for suitable fund selection.

Establishing a successful mutual fund portfolio is a three-step process: (1) identifying investment objectives and preferences, including portfolio amount, return objectives, time horizon and risk tolerance; (2) formulating a detailed asset allocation strategy by fund type category to reflect chosen objectives; (3) suitable fund selection to match each category. The second step is the most challenging due to the abundance of asset allocation theories and strategies. Most asset allocation strategies fall into two groups: one primarily treats risk as a stock/bond allocation, with risk tolerance changing the percentage of stock and bond funds; the other is primarily a fund category allocation, with risk tolerance affecting the type of fund categories and their allocation percentages within a basic stock/bond allocation. For additional information on this subject, go to "The Role of Risk in Mutual Fund Strategies".

Regardless of which asset allocation method an investor prefers, the important message is clear: to avoid the pitfalls of haphazard fund selection, develop a detailed asset allocation strategy which accurately represents your investment objectives and preferences.

 Over-Weighting in High-Risk, Non-Diversified Funds 

This mistake is a specific example of portfolio imbalance: a very large percentage of total portfolio assets are concentrated in funds with very high risk/reward characteristics, even though the fund types may actually reflect chosen investment objectives. The result is excessive volatility in the price movement of these funds which, in many instances, can cause disappointing portfolio performance because the very large percentage of risk does not justify the potential reward -- in other words, the risk is highly disproportionate to overall profit potential. Over-weighting can occur with any type of risk tolerance, although this specific type of over-weighting is more likely to be a problem in portfolios with aggressive risk tolerances.

High-risk, non-diversified stock fund categories include domestic and foreign small-cap growth, emerging markets and sector funds; in bond categories, emerging market and certain high-yield funds are also high risk. These fund types can be appropriate in many portfolios, provided an investor adheres to the principles of effective diversification: distinct risk/reward objectives within a variety of fund types and a reduction in overall portfolio risk.

Is there an acceptable percentage of high-risk, non-diversified funds to own in a portfolio? Most guidelines suggest between 5-30% of total portfolio assets, depending upon the choices of aggressive, moderate or conservative risk tolerances and growth, balance or income-oriented return objectives. The key is to treat high risk, non-diversified mutual funds as a suitable portfolio supplement without dramatically increasing overall risk.

 Duplication of Fund Categories 

This type of mistake is an example of inefficient diversification and occurs when an investor has two (or more) funds with identical objectives. For instance, owning two small-cap growth funds, two large-cap growth funds and one intermediate corporate bond fund in a five-fund portfolio is inefficient diversification due to the duplication of fund objectives in the small and large-cap growth categories; in this arrangement they lack the variety of distinct risk/reward characteristics of ideal diversification. To avoid duplication, it is best to represent a fund category with just one fund.

The underlying common factor in avoiding these three common mistakes is appropriate detailed asset allocation: it provides effective diversification and eliminates the problems associated with haphazard fund selection -- it is the key in establishing a successful mutual fund portfolio.