The Investing Secret You Need to Know

You can count on the mutual fund industry to hype its hottest products, no matter what they happen to be at the moment. Until last year, the rising market had everyone pushing their way into stock funds, especially those focusing on soaring sectors like energy and emerging markets stocks.

Lately, the economic recession and the accompanying bear market have everyone thinking more defensively about their investments. Those bullish funds have gone back into the drawer, and now you hear about the virtues of bear market funds, market-neutral investments, and alternatives like balanced funds, which carry less risk than mutual funds that only own stocks.

But all these types of mutual funds only obscure the real point. With a good investment strategy based on the right asset allocation to meet your financial goals, you can find any number of ways to execute it -- and which stocks or funds you pick don't necessarily make a huge difference.

Different funds, same investments
Consider, for example, this situation. Which portfolio would you rather own?

• One mutual fund that lost 22% last year.
• Two funds, with 60% of your money in a fund that lost 37% in 2008, and the rest in another fund that gained 5%.

Clearly, neither portfolio is all that attractive. Your first answer would probably be, "I'll just take the 5% winner and leave the rest."

But if you found out that the fund in the first portfolio was a balanced fund, you might gravitate toward it. Following common wisdom, you might figure that since investments are risky right now, and balanced funds reduce risk, you'd be better off with the more conservative choice.

The same thing
Now let's take a closer look at these portfolios:

Source: Morningstar.

For all practical purposes, these portfolios are pretty much identical. They both offer a 60/40 split between stocks and bonds. They both hold the same mix of large-cap stocks you'd expect to see in index funds.

Yet oddly enough, if you managed your own asset allocation rather than letting the balanced fund do it for you, you did better. The weighted average return on the second portfolio was a loss of just 20% -- two percentage points better than the balanced fund.

Make your own mix
In addition to absolute performance, there are several other reasons why putting together your own mix of funds in accordance with your asset allocation may lead to better returns. Here are a few of them:

• Specialization. Try as they might, fund managers can't master the entire investing world. For instance, fund family Parnassus has proven itself a great small-cap investor, with its small-cap fund creating great performance on the back of stocks like Ormat Technologies (NYSE:ORA) and Teleflex (NYSE:TFX). But its large-cap growth fund, while not terrible, hasn't been as consistent, having suffered from bad calls on Wells Fargo (NYSE:WFC) and Google (NASDAQ:GOOG). By making your own mix, you can put together the best fund portfolio possible.
• Optimization. If you have all your money in one fund, you either have to take it or leave it. With a multi-fund portfolio, however, you can make changes more easily, rejecting a bad performer in one area without goofing up your entire strategy.
• Taxes. Balanced funds that target certain asset allocation percentages are forced to sell investments in order to rebalance, often creating tax liability. With separate funds, you control when you rebalance, and you can time your own trades to minimize taxes.

So before you move to a more conservative fund, consider whether what you really need is a more conservative mix of great funds. It may be that by reallocating money among funds you already own, you'll do far better than if you abandon your existing strategy and jump to the next hot investment.

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