"Like dieting, investing is simple but not easy," says Jason Zweig in The Little Book of Safe Money. It's not so much about who is the smartest at picking stocks and timing portfolio moves, it's more about having the discipline to stick with a long-term asset allocation – as found in the seminal 1986 and 1991 studies published in the Financial Analysts Journal by Gary Brinson and co-authors.
Failure to stick with the right asset mix is perhaps the most common reason for not succeeding. "If you want to see the greatest threat to your financial future, go home and take a look in the mirror," quips Larry Swedroe in Wise Investing Made Simple.
Here are 12 pointers to keep in mind when building a portfolio with mutual funds, as we head toward the RRSP deadline of March 1st.
1. Long-term focus: Near-term predictions about which asset types will perform best "are at best unreliable," says Tom Bradley, co-founder of Steadyhand Investment Funds and author of It's Not Rocket Science. "But when making projections over longer time frames, the crystal ball gets less cloudy. We know that stocks tend to beat bonds, and bonds tend to beat cash."
2. Smooth the volatility: However, "very few investors who hold only stocks have the fortitude to ride out a severe, prolonged market downturn," argue Andrew Clarke and Jack Brennan in Wealth of Experience: Real Investors on What Works and What Doesn't. To smooth volatility and improve chances of staying the course, bond and money-market funds are usually added to the portfolio.
3. Hedge the long-term risk: Although stocks have historically provided the best average annual return over long periods, there is a lot of variation in where the average ends up – and there is no money-back guarantee that it will necessarily be positive. "Invest as if stocks are likely – but not certain – to beat all other assets. Keep some money in bonds, cash and real estate just in case they do better," cautions Mr. Zweig.
4. Select the right equity allocation: The higher the allocation to equities the better, but it needs to be tempered by the time horizon and circumstances of the investor. One rough rule is that the percentage of equities should equal 100, less one's age. Risk-tolerance questionnaires are also used, but heed this warning from Walter Updegrave, author of We're Not in Kansas Anymore: "In the euphoria of a bull market investors think they're much bigger risk takers than they really are."
5. Rebalance back to the strategic asset mix: Mr. Bradley is a "tilter," meaning he will adjust his asset mix moderately in response to stock-market valuation and sentiment. But most investors are better off going to autopilot and adjusting back to their strategic asset allocation by adding new money to lagging assets. "The mind-numbing decision of what to do at the RRSP deadline will be an easy one – allocate your contribution in line with your long-term mix," Mr. Bradley says.
6. Diversify using stocks: Academic studies show small-cap and value stocks tend to outperform other types of stocks over the long run, so some portfolios may tilt toward them. And there are opportunities to invest and diversify in foreign stocks: "I've been using the strong loonie to increase my weighting in foreign stocks," says Mr. Bradley. "They have lagged behind my domestic holdings mostly because of currency."
7. Diversify using bonds: Long-term and corporate bonds have greater correlations with stocks, so bond funds emphasizing short-term and government bonds stabilize portfolios more and allow greater equity risk, say the authors of The Only Guide to a Winning Bond Strategy. Benjamin Graham suggests in The Intelligent Investor that medium maturity bonds "enable you to get out of the game of guessing what interest rates will do."
8. Diversify by assets, not funds: Many investors think diversification is achieved at the fund level, say professors Richard Thaler and Shlomo Benartzi. Their study discovered that members of U.S. defined-contribution pension plans spread savings evenly over the menu of funds offered so that people in plans with relatively more equity funds had higher allocations to equities. Investing in a dozen mutual funds covering the same market does not reduce risk.
9. Check under the hood: To achieve a desired asset mix, examine funds carefully. For example, a fund classified as "Canadian equity" might have 10 per cent in cash and 30 cent in foreign stocks. As such, it would not fully represent the investor's preferred weight for Canadian stocks. If the proportion of multinational companies in the fund is high, there could be even greater dilution.
10. Cut costs if you're not getting value: Financial advisers can help investors avoid the pitfalls. But if you feel they do not add enough value, consider buying directly from companies like Phillips, Hager and North Investment Services, Steadyhand Investment Funds and Mawer Investment Management. Annual management fees are less than 1.5 per cent and you often gain access to free, unlimited expert advice, says Margot Bai, author of Spend Smarter, Save Bigger.
11. No closet-index funds, please: Avoid actively managed funds with portfolios of stocks similar to the index. The same performance can be achieved with an exchange traded fund (ETF) charging 0.2 per cent annually instead of the average 2.4 per cent levied by actively managed Canadian equity funds. If you are paying up for a shot at beating the market, look for funds with concentrated portfolios (less than 30 stocks) and sector weights different than the index.
12. Consider the KISS option: The fewer decisions your portfolio requires, the fewer the mistakes plus the more time in the armchair. "The simplest of all approaches is to invest solely in a single balanced market index fund," advises John Bogle in Common Sense on Mutual Funds. Which one? Dan Hallett of HighView Financial Group has long recommended the Mawer Canadian Balanced RSP, a global balanced fund with a management expense ratio of 1 per cent.
Craig Porter, portfolio manager at Front Street Capital, took your questions and offered his insight on investing in the energy sector in this live Globe and Mail discussion. Mr. Porter's CIBC Energy fund is among Lipper's top-ranked Canadian energy funds, with a three-year annualized return of 10.5 per cent. Read more on his selection process here. He also runs the Front Street Resource Fund, which was up 55 per cent in 2010.
Readers using mobile phones should read the discussion by following this link.