A fund manager who quickly buys and sells a compact portfolio of high-priced, fast-growing companies will produce different results from a manager who owns 300 stocks of larger companies with lower earnings and cheaper prices.

Mutual funds have some advantages over individual securities: professional management, which eliminates the need to analyze specific investments, diversification, which minimizes your losses if certain securities do poorly and liquidity. Mutual funds also offer the added attraction of low initial investment and low annual fees. Often, all it takes is a phone call to buy or sell shares.

Mutual-fund investing, however, requires the same careful investigation as any other investment vehicle. You need to do more than give a fund the once-over before investing in it. Knowing that the fund has been a good performer in the past isn’t enough to warrant financial risk. You need to understand what’s inside its portfolio, or how it invests.

The information you uncover will tell how the fund behaves. Your research will help you set realistic expectations. A fund manager who quickly buys and sells a compact portfolio of high-priced, fast-growing companies will produce different results from a manager who owns 300 stocks of larger companies with lower earnings and cheaper prices. Unless you know what a fund owns, you can’t determine what role the fund fills in your portfolio. For a fund to fill the large-cap growth portion of your portfolio, you need to know that it actually invests in large-growth companies. Finally, examining a fund’s portfolio can tip you off to risks the fund may be harboring, risks that might not have surfaced yet.

Mutual funds are only as good as the people behind them, the fund managers. Managers are the professionals who decide what to buy, what to sell, and when. Knowing who calls the shots and for how long is key to smart mutual fund selection.

A few questions to ask before buying a fund:

• How has the fund performed?
• How risky has it been?
• What does it own?
• Who runs it?

Should an investor own only one mutual fund? There is no ideal number of funds to own. What is of utmost importance, is how diversified your portfolio is, regardless of how many funds are in it. If all of your funds are growth funds, or overweighted in a particular sector, you could own dozens of funds and still not be adequately diversified. Conversely, a one-fund portfolio could be better diversified than a multifund portfolio.

 

Building a Mutual-Fund Portfolio

As with stocks, how to invest depends on who is doing the investing. There is just no one-size-fits-all, no one correct way to building a mutual-fund portfolio. Putting together a group of funds is a matter of personal preference and personal goals. But there are some universals you should think about when choosing and combining funds.

Define your objectives and priorities. This is probably the toughest part of the investing process, sitting down to figure out why you’re investing, what you’re investing for, and how much money you’ll need to reach that goal. Your goals and your risk tolerance should then determine what your portfolio looks like.

Your goals and your tolerance for market fluctuations might not be in sync. You may find that you can’t imagine losing 20 percent in one quarter, but you need to invest aggressively to have a shot at accumulating the return you’ll need to reach your goal. If so, you will need to compromise by either accepting the risk or changing your goal.
Time plays a part as well. If your goal is to retire in 30 years, you might be more willing to take on volatility, since you can spread your risk over a longer time period. If you suffer a loss, you will have time to make up for it. But if your goal is just 5 years away, taking on more risk might not be a good idea.

Avoid Portfolio Overlap. One of the problems you may face is having one or two individual stocks, investment styles, or sectors over-represented in your portfolio of mutual funds. After investing for a while, investors often find that although their funds may have different wrappers, many have similar content.

 

When to sell a fund

While most of us can agree on what to look for when buying a fund, good risk-adjusted returns, long manager tenure, we tend to part ways on when to sell. None of us wants to be one of those investors who undermines his or her returns by buying and selling at the wrong times. Yet some situations almost demands that we hit the sell button.

Consider selling if:

Jodye Deal is the owner of Gazelle Associates (www.gazelleassociates.com), an investment planning firm based in Virginia. If you have any questions about investing please call Deal at (703) 995-4491 or send an e-mail to her via investing@gaze lleassociates.com.