For many investors, a solid mutual fund performs in line with its benchmark; for others, it’s a fund that zooms ahead of the market. But these aren’t necessarily the best ways to judge a fund.
Mutual funds, like the stocks and bonds they hold, are subject to market cycles. Sometimes they perform well and other times they perform poorly. Some investors try to “time the market,” by moving in and out of a fund, but this can be costly. The market moves quickly; you could easily end up selling low and buying high, triggering a higher tax bill.
Portfolio managers also haven’t the flexibility to adjust their portfolios to meet changing market cycles; a bond-fund portfolio manager is usually required by the fund’s prospectus to invest in bonds – even when the bond market is down.
A diversified portfolio based on your goals, risk tolerance, and time horizon can minimize market concerns. It won’t eliminate risk, but a diversified portfolio can help provide you a cushion in a downturn. When some funds perform poorly, others may be performing well. This balances your overall return.
Just as goals, risk tolerance, and time horizon help you create your portfolio, these factors should also guide you in deciding when to change it.
In creating your portfolio, you were required to consider how much volatility you can tolerate. If your portfolio begins to exceed your volatility tolerance, re-examine it. You may want to consider dropping losers.
However, this can be a difficult decision; ask your advisor for help.
Investors own mutual funds, in part, to create a diversified portfolio that includes a number of asset classes and securities. But in their effort to diversify, some may inadvertently have invested in many of the same asset classes and securities. This overlap could result in a portfolio that is inconsistent with their financial goals and risk tolerance.
How does overlap occur? Your funds could hold some securities in the same asset class, such as large-cap stocks. And they could even hold some of the same securities.
To detect overlap, you could look at the top 10 holdings for each fund you own (generally available in shareholder reports and fact sheets), determine the asset class for each holding, then see if there is any repetition among asset classes and securities. Or you could ask your advisor.
Your advisor may not be aware of all your holdings, and therefore would be unable to spot duplications. You can save your own time and energy, by asking him or her to help you sort through your portfolio to find any potential overlaps.
Ideally, you will already have a target asset allocation, or target mix of asset classes and sectors. If you or your advisor uncover any asset class overlap in your portfolio, you may want to take steps to correct it. He or she likely will recommend you gradual shift investments into asset categories and industries where you need to increase your exposure.
To prevent future overlap, you should be careful not to purchase a mutual fund or stock without considering its effect on your overall investment strategy. Even if you don’t make changes, you and your advisor should probably check your portfolio regularly for overlap resulting from market changes.
Your focus should be on your long-term financial goals. Build an annual portfolio checkup into your plans to ensure against overlap.