How to build a mutual-fund portfolio

Now more than ever we think you need to invest in only the highest-quality mutual funds. Here are some keys to building a sound portfolio with these mutual funds.

Diversify. Spread your portfolio out over several funds that practice a variety of investing styles. Vary your exposure to each style to reflect your individual financial circumstances, temperament and goals.

Invest in just a few funds. We feel most mutual fund investors should own no more than five funds. When you own a larger number of funds, you increase your risk of becoming too diversified. The more funds you own, the more likely you are to earn a return equal to the market average, minus the 2% to 3%, or more, that it costs to invest in a fund. As well, owning too many funds guarantees mediocre results. With too many funds, you can lose track of what you own, and you may wind up holding when you ought to sell. If you do invest in a winner, it’ll be too small a part of your portfolio to make a difference in your overall returns.

Insist on investment quality. Invest only in funds that stick to high-quality investments. To put it another way, stay out of funds that dabble in junk.

Stay out of bond funds. Bonds are unlikely to perform as well over the next few years as they have over the last few, if only because interest rates may hold steady or rise. This means bond funds would only earn interest income on their bonds; instead of capital gains, their bond holdings could produce capital losses.

Get personal security. One of the best things you can do as a mutual-fund investor is choose funds whose managers feel some personal connection to the funds they manage, and to the investors who have money in those funds. If the manager’s prestige, career and personal fortune rises, or falls, with the fund’s long-term results, so much the better.

A foundation of conservative funds

We think most investors should focus on mutual funds that invest mainly in large, well-established U.S. and Canadian companies. Funds like these should make up between one-third and two-thirds of most fund investors’ portfolios.

Small caps add growth potential

When chosen wisely, small cap stocks — those with a market “cap” or capitalization (the total value of all the company’s outstanding shares) of less than, say, $500 million — can grow at a faster rate than the rest of the market. However, small cap funds are more volatile than funds that focus on larger companies, and they expose you to greater risk.

Foreign funds have appeal

We don’t advise investing a lot of your portfolio in foreign markets — they are generally more volatile and risky than North American markets. However, we do think one of the best ways to invest in foreign markets is through mutual funds.

A model portfolio

Here’s a portfolio for a conservative growth investor with $20,000 to invest.

$5,000 Ivy Canadian
$5,000 Templeton Growth
$5,000 TD Canadian Small Cap Equity
$5,000 Fidelity Growth America

Ivy Canadian Fund invests in high-quality, large-cap Canadian stocks, well balanced across the five main economic sectors (Manufacturing & Industry, Resources, Consumer, Finance and Utilities).

Templeton Growth Fund is well diversified, both among countries and between economic sectors. Its attention to fundamentals such as such as earnings, cash flow and low debt, and its avoidance of fads, gives investors global exposure with reasonable risk
.
The conservative growth investor can accept the volatility that TD Canadian Small Cap Equity Fund entails. The fund invests in small cap companies that are making money, have strong balance sheets and have sound long-term prospects.

Fidelity Growth America Fund — as shown in another article in this issue (click here).