The 3 Familiar Mistakes In Mutual Fund Investing

Effective diversification.....appropriate asset allocation.....proper fund selections. These are some of the basic objectives that every investor desire in a mutual fund portfolio. Irrespective of the investor’s stage (whether in asset accumulation stage or in asset withdrawal) these goals are essential for successful mutual fund portfolios. However, an investor can meet many pitfalls or roadblocks in their quest to achieve these goals. The article explores three of the most common impediments and offers suggestions on how to avoid them.

 Familiar Mistake 1: Lack of Investment Strategy 

This is perhaps the most common mistake in mutual fund investment. I am always surprised by the huge number of investors who select specific mutual funds devoid of giving any thought to an asset allocation plan. Many individuals may actually identify and define their investment goals, but then skip the next crucial step in setting up a successful mutual fund portfolio: crafting a detailed asset allocation Plan. With no suitable asset allocation plan that accurately echoes individual investment preference and objectives (return objectives, time horizon, risk tolerance, etc), the process of selecting mutual funds will haphazard instead of logical.

Pending very few exceptions, the result of haphazard mutual fund selection is improper asset allocation, which in turn leads to ineffective portfolio diversification -- with the end result being poor portfolio performance. True to the old men’s words, “Failure to plan is planning to fail.”

On the other hand, effective portfolio diversification is a direct result of an appropriate and detailed asset allocation plan that fits individual investment goals and preferences. Effective diversification spreads the assets among different mutual fund categories to attain both a variety of distinct reward/risk objectives and a decrease in overall risk. Appropriate asset allocation not only eradicates undesirable characteristics of under-weighting, over-weighting and inappropriate mutual funds, it accurately matches fund type and their percentage of investment assets to specified goals – simply put, it is the "blueprint" for effective fund selection.

Setting up a successful fund portfolio is a three-step process:

1.     Identifying your investment objectives, goals and preferences, e.g. return objectives, portfolio amount, risk tolerance and time horizon;

2.     Formulating a comprehensive asset allocation strategy by fund category to reflect preferred objectives;

3.     Appropriate fund selection to match each category.

The second step is the most difficult due to the plenty of asset allocation strategies and theories. Most investment asset allocation strategies fall into two main categories: one mainly treats risk as a bond/stock allocation, with risk tolerance varying the percentage of bond and stock funds; the other is basically a fund category allocation, with risk acceptance dictating the type of fund groups and their allocation quotas within a basic bond/stock allocation.

Regardless of the asset allocation method you prefer as an investor, the important message is clear: avoid, at all costs, the danger of haphazard fund selection, produce a detailed asset allocation plan which precisely represents your investment goals and preferences.

Familiar mistake 2: Over-Weighting in High-Risk funds,

This is a specific example of portfolio imbalance where a very large quota of your total investment assets are concentrated in funds with very high reward/risk characteristics, even though the fund categories may actually echo chosen portfolio objectives. The end result is too much volatility in the price movement of these funds which can cause disappointing investment performance because huge percentage of risk does not justify the impending reward. Over-weighting can happen with any type of risk acceptance, although over-weighting in high risk funds is more likely to be a problem.

High-risk stock fund categories include emerging markets, small-cap growth (both domestic and foreign) and sector funds; in bond categories, emerging market and some high-yield funds are also high risk. These fund categories can be suitable in many portfolios, so long as an investor sticks to the principles of effective diversification.

Is there a tolerable percentage of high-risk funds to own in an investment portfolio? Most strategists suggest between 5-30% of total investment assets, depending on the choices of conservative, moderate or aggressive risk tolerances and growth, income-oriented return or balance objectives. The key is to treat high risk mutual funds as an apposite portfolio supplement without significantly increasing your overall risk.

 Familiar Mistake 3: Duplicating of Fund Categories 

This is an example of inefficient diversification and arises when an investor has two (or more) mutual funds with similar objectives. For example, owning two large-cap growth funds, two small-cap growth funds, and one intermediate corporate bond in a five-fund investment portfolio is inefficient diversification due to the replication of fund objectives in the large and small-cap growth types; in this strategy they lack the diversity of distinct reward/risk characteristics of idyllic diversification. To evade duplication, it is good to represent a fund category in your portfolio with just one fund.

The fundamental common factor in keeping away from these three common mistakes is appropriate comprehensive asset allocation: it provides effectual diversification and eradicates the problems allied to haphazard fund selection -- it is the key in setting up a successful fund portfolio.