Now that you've built your portfolio of mutual funds, you need to know how to maintain it. Let's talk about how to manage a mutual-fund portfolio by reviewing four popular strategies.
The Wing-It Strategy
This is the most commonly seen mutual-fund strategy. How does it work? Basically, if your portfolio does not boast a plan or structure, then it is likely that you are employing a wing-it strategy. If you are adding money to your portfolio today, how do you decide what to invest in? Are you someone who searches for a new investment because you do not like the ones you already have? A little of this and a little of that? If you already have a plan or structure, then adding money to the portfolio should be very easy. Most experts would agree that this strategy tends to be least successful because of its lack of consistency.
The market timing strategy implies the ability to get into and out of sectors, assets, or markets at the right time. In an ideal world, the ability to time the market means that you would always buy low and sell high. Unfortunately, few investors do this consistently because investor behavior is typically driven by emotions instead of logic. The reality is that most investors tend to do exactly the opposite of what is optimal – i.e. buy high and sell low. This leads many to believe that market timing does not work. No one can accurately predict the future with any consistency, yet there actually are many market-timing indicators.
This is by far the most widely preached investment strategy. The reason for this is that statistically speaking, the odds are on your side. Markets generally go up 75% of the time, falling only 25% of the time. If you employ a buy-and-hold strategy and weather the ups and downs of the market, you will make money 75% of the time. If you are to be more successful with other strategies for managing your portfolio, you must be right more than 75% of the time in order to be ahead. The other issue that makes this strategy the most popular is that it's easy to employ. This does not make it better or worse than the other options; it's simply easy to buy and then to hold.
This is somewhat of a middle ground between market timing and buy-and-hold. With this strategy, you will revisit your portfolio mix from time to time and make some adjustments. Let's walk through an oversimplified example using real performance figures.
Let's say that at year-end 2010 you started with an equity portfolio of $100,000 across four mutual funds, split into equal weightings of 25% each.
After the first year of investing, the portfolio is no longer weighted equally at 25% in each fund, because some funds performed better than others.
The reality is that after the first year, most investors are inclined to dump the loser (Fund D) for more of the winner (Fund A). That, however, is not what performance weighting is about. Performance weighting simply means that you would sell some of the funds that did the best to buy some of the funds that did the worst. Your heart will go against this logic, but it is the right thing to do, because the one constant in investing is that everything is cyclical.
In year four, Fund A has become the loser and Fund D has become the winner.
Performance-weighting this portfolio year after year means that you would have taken the profit when Fund A was doing well to buy Fund D when it was down. In fact, if you had re-balanced this portfolio at the end of every year for five years, you would be further ahead as a result of performance weighting. It's all about discipline.
The Bottom Line
The key to portfolio management is to have a method that you adhere to in a disciplined fashion. The most successful money managers in the world are successful because they have the discipline to manage money, and they have a plan. Warren Buffet said it best: "To invest successfully over a lifetime does not require a stratospheric I.Q., unusual business insight, or inside information. What is needed is a sound intellectual framework for making decisions, and the ability to keep emotions from corroding that framework."