As you develop an investment plan built around mutual funds, think in terms of a portfolio instead of a single fund. A collection of four to nine funds of different varieties should be adequately diversified.
Building a well-diversified portfolio guards against a particular investment style going out of favor and taking you down with it. It also helps protect you from a manager's mistakes. Even the savviest managers occasionally turn cold for a time, so owning several funds helps protect you from bearing the brunt of a single manager's off year.
Allocating your money among stocks, bonds and cash could be your most important investment decision. That's because asset selection usually has more to do with your ultimate return than the specific issues you pick.
Your stock-bond breakdown should hinge on two things:
First, how much time will pass before you need the money? The longer your time horizon, the more you can afford to invest in stocks. When you're investing for retirement ten or more years away, you should have substantially all of your assets in stocks. Someone saving to buy a home or to pay a college tuition bill in five years should have about 50% of the portfolio in stocks. Practically speaking, most people invest for more than one purpose, so if you pick a group of funds for each goal, the overall result will be a portfolio somewhat balanced between stocks and bonds.
Second, honestly assess your tolerance for risk and volatility. You must be able to withstand the stock market's downturns to benefit from its long-term generosity. If you're spooked and sell your stock funds every time they drop 15% or 20%, you're likely to return only after stocks have staged dramatic rallies.
Every year the editors of Kiplinger's Personal Finance magazine put together portfolios of funds for various investment time horizons or goals. Each example portfolio provides a percentage for each fund as well as a cost estimate to get up and running.
Selecting stock funds
Fsirst decide how much of your stock investments should be in U.S. stock funds and how much in funds specializing in foreign stocks. The U.S. represents just 50% of the world's stock-market capitalization, so we think it also makes sense to invest 15% to 30% of your stock portfolio in overseas issues.
Now turn back to domestic stock funds. The easy way to diversify is to choose an exemplary fund from each of three categories: aggressive growth, long-term growth, and growth and income (making sure you don't choose funds that own the same kinds of stocks). Allocate more of your money to the aggressive fund if your time horizon is long and your risk tolerance high, or toward the growth-and-income fund if the reverse is true.
Selecting bond funds
The most important decisions you have to make with bond funds involve the maturities of bonds they own and the quality of those issues.
In general, the longer a bond's maturity, the more it yields. But longer maturities also mean greater risks. As for quality, the "junkier" a bond, the more it generally yields. However, lower-quality bonds may fall in value if investors perceive more difficult conditions ahead for their issuers or for the economy in general.