The first and most important quality of a portfolio is that it be diversified. A portfolio should contain stock mutual funds as well as mutual funds that contain bonds. How much of each you should include depends on two things: time horizon and risk tolerance.
The time horizon needs to correspond to the time horizon of the goal the portfolio is to fund. For example, if the time horizon for the portfolio is retirement in 20 years, the portfolio can have more stock mutual funds that will fluctuate in value over time, as well as have the potential to earn more than bond funds.
If, however, the time horizon for the portfolio is retirement in three years, the portfolio would allocate less to stock funds and more to bond funds to provide more stability to the portfolio, with the understanding that the return will likely be less. Bond funds also have the potential to provide income.
Next, the risk tolerance of the investor comes into play. One way to assess one's risk tolerance is the ability of the investor to withstand the ups, and more importantly, the downs, of the market. One simple way to assess one's risk tolerance is the "sleep at night" test. If one is losing sleep at night worrying about the portfolio, the stock exposure of the portfolio is probably too high for one's risk tolerance.
One of the biggest mistakes investors make is selling at the worst possible time, when the market has dropped significantly. Having a portfolio consistent with one's risk tolerance helps prevent investors from making this mistake. Every investor's risk tolerance is unique to them and there are many risk tolerance questionnaires on the internet to assist in coming up with a suggested asset allocation.
After determining how much of the portfolio to allocate to stock funds versus bond funds, it is time to spread the stock allocation among mutual funds that invest in different areas of the market. Mutual funds typically invest in small, middle or large market capitalization stocks (often called small-cap funds, mid-cap funds and so on) as well as international stocks. Additionally, some mutual funds invest in a blend of stocks and bonds.
Portfolio managers tend to invest with different styles of either growth or value. Growth fund portfolio managers will invest in stocks with earnings they believe will grow at an above average rate compared to the company's industry or the overall market. Value portfolio managers prefer to invest in stocks they feel are undervalued by the market.
Ideally, a portfolio should have both growth and value mutual funds in each market capitalization area. Although this may seem like a bit of overexposure, an all-weather portfolio should be just that. It should be constructed to weather all of the different market cycles that are bound to continue in the coming years. The market will have periods of rapid growth and positive returns, but it will also have periods of slow growth and even negative returns. Sometimes smaller capitalization stocks will outperform larger capitalization stocks and vice versa.
There will be times when value stocks outperform growth stocks and vice versa. The point is that no one can consistently predict the market. If a portfolio has mutual funds with exposure to various areas of the market, no matter what area is outperforming the overall market, a portion of the portfolio will be participating. Conversely, if one area of the market is underperforming the overall market, only a portion of the portfolio will be negatively impacted.
Over time, most investors find a portfolio that provides a smoother ride is preferable to one that has wild swings of strong positive performance with the equally disconcerting downward spiral of negative performance. Staying invested through all market cycles is the goal and the point of an all-weather portfolio.
Lastly, the final cornerstone of an all-weather portfolio is a healthy cash contingency. With this cash cushion, if cash is needed for planned or unplanned expenses, no mutual funds will need to be liquidated. This is especially important if the market is down when the cash is needed.
With a healthy cash position and mutual funds invested in stocks and bonds across different areas of the market, a portfolio has a good chance of withstanding any kind of "weather" the market may encounter.
Karen Ramsey has over 20 years of experience as a fee-only certified financial planner professional. The author of two books on personal finance, she provides professional investment management to clients throughout the U.S. via her low-account minimum, web-interactive service RamseyInvesting.com.
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