Mutual fund investing -- what could be easier? You just find a few decent funds with solid performance and long-tenured managers. Then you can sit back and let those experts do all the work, right? Not so fast. There's one more part to this equation: allocating your money among all of your funds. Surprisingly, it may be one of the most important investment decisions you'll make.
Slicing the pie
The investment industry has debated the importance of asset allocation for many years. A landmark study written by Gary Brinson, Brian Singer, and Gilbert Beebower more than 20 years ago concluded that investment policy, including asset allocation, determined more than 90% of total return variation. Security selection ultimately determined less than 5% of the returns. In short, it didn't really matter what stocks you bought, but rather whether your chosen mix of stocks and bonds was right for your portfolio. These results have been debated in subsequent years, but nonetheless, asset allocation is something Fools shouldn't overlook.
On the surface, the idea that it doesn't matter which stocks or bonds or mutual funds you buy sounds dead wrong. You should definitely do your research before buying stocks or mutual funds -- but remember, that's only the first step.
Allocating your funds
The biggest factors in how you allocate your investment portfolio are your age, risk tolerance, and time horizon.
If you're in your 20s or 30s, you have many more years in the working world still ahead of you. Since you'll have time to recover from any market downturns that may occur, you should be more aggressively invested, devoting little space in your portfolio to fixed-income investments.
Make sure you have exposure to both growth and value large-cap funds. Growth funds will often include stocks like Cisco Systems (NASDAQ:CSCO) and PepsiCo (NYSE:PEP), while value funds own companies such as Pfizer (NYSE:PFE) and ExxonMobil (NYSE:XOM). This should form the "core" of your portfolio -- between 50% and 70% of your assets. Exposure to small- and mid-cap funds should account for roughly 10%-20% of the portfolio, while international funds should be anywhere from 15% to 25%. It's probably not a bad idea to own a small position in a widely diversified fixed-income fund, but if you do, limit it to around 5% of your holdings.
In your 40s, bonds should take a more prominent place in your portfolio. Decrease large-cap holdings to between 30% and 50% of the portfolio, with small-cap, mid-cap, and international funds each composing between 5% and 15% of overall assets. Bonds should now make up around 35% to 45% of your portfolio, to dampen the volatility of returns.
Investors in their 50s and nearing retirement should obviously focus more on preserving their capital than should their younger counterparts. In this case, fixed-income investments should make up a majority of the portfolio, between 65% and 75% of assets. However, your portfolio will still need to grow to fund your later retirement years, so it's important that you have some exposure to equities, even as you enter retirement. In this scenario, large-cap funds might make up 15%-25% of your portfolio, with small-cap, mid-cap, and international funds around 5% each.
Staying active
Remember that these asset-allocation targets are suggested ranges. Your portfolio may look different, depending on your own individual needs and objectives.
Finally, make sure you rebalance your portfolio from time to time. Move your money from areas of higher to lower valuation. If international stocks have had a good run-up, put more of your new money elsewhere. If you think growth stocks will make a comeback, up your allocation to your large-cap growth fund. Don't assign hard targets to your allocations; instead, set flexible ranges than can vary as market conditions change. Making these kinds of adjustments based on the current market environment can be a big help in juicing your investment returns, and ensuring that you reach your retirement goals. Happy allocating!
Further fund-amental Foolishness:
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Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies or funds mentioned herein. Pfizer is an Inside Value recommendation. The Fool's disclosure policy supports you 100%.
