Why investors should avoid asset allocation funds

Many investors buy units of asset allocation mutual funds because they think these funds provide an easy and profitable way to diversify between stocks, bonds and cash equivalents.

How asset allocation funds work

Asset allocation funds are mutual funds that can shift their portfolio allocations between stocks, bonds and cash in order to capitalize on perceived investment opportunities in any one of those classes.

For example, if the managers feel that the bond market is depressed and poised for an upswing, they may overweight the portfolio in fixed-income investments for a few months to take advantage of the change.

Some managers use judgment calls to choose between stocks, bonds and cash, while many use a so-called “black box” — a computer program that makes trading decisions based on a preselected set of rules for interpreting financial statistics. Computer modelling makes this investment approach sound scientific, but it is just as likely to detract from a portfolio’s long-term return as it is to add to it.

Holding bonds — through asset allocation funds or otherwise — will likely hurt your long-term returns

The performance of bonds is inversely related to the rise and fall of interest rates; when rates fall, bond prices go up.

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With interest rates now at historic lows, bonds can’t go a lot higher than they are. In fact, it seems more likely that rates will hold steady or rise slightly in the short term, and move higher in the long run. That means asset allocation mutual funds would only earn interest income on their bonds; instead of capital gains, their bond holdings could produce capital losses.

Our long-term strategy puts you in a better position to profit than asset allocation funds

Instead of asset allocation mutual funds, we think you would be far better off investing in well-established, high-quality dividend-paying stocks. If you want to hold these stocks in a mutual fund, you could choose from the funds we recommend in our special report, “Mutual Funds Canada: Inside the Top 10 Canadian Mutual Funds.”

Moreover, you can eliminate market-timing risk by spreading your money out across most, if not all, of the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; and Utilities). This way, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or changes in investor opinion.

You also increase your chances of stumbling upon a market superstar — a stock that does two to three (or more) times better than the market average.

Here’s an alternative to an all-stocks portfolio

If you are reluctant to hold a 100%-stocks portfolio — and many people are — then one alternative to consider is to keep a portion of your investment funds in relatively short-term fixed-return investments, with maturity dates of a few months to no more than two to three years in the future.

These fixed-return investments will lose value when interest rates rise, but not enough to make a serious dent in their value. You can hold them till maturity, then get your money back and reinvest.

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