Constructing a Diversified Portfolio of Mutual Funds

Putting together a portfolio of mutual fund investments is similar in most ways to constructing a portfolio of stocks, bonds and other securities. The primary objectives are to select various combinations that will give you good diversification among company size, industries, and sectors while being positively reactive to the current economic conditions. Stocks should be mixed with bonds to temper the upside and downside swings in the markets. Similarly, stock mutual funds should be selected along with bond funds to temper the market swings.

Investors usually use two approaches, or a combination of the two, when constructing their portfolio of stock mutual funds.

Diversification Based on Size and Style of Companies

Many average investors buy mutual funds and hold them for the long term. Therefore, they usually select mutual funds which contain large company stocks (large Caps) which are diversified by investment Style. The primary investment styles are Growth stocks, Value stocks or a Blend of both. Once they have one or two of these large mutual funds, they will then often times add a fund which invests in smaller companies (Small Caps). Small cap funds are riskier than large cap funds, and provide more upside investment potential. The small cap stocks or funds may also have either a Growth or Value or Blend investment style.

Such a portfolio will perform fairly well during all economic cycles compared to a portfolio which is invested totally in stocks or totally in bonds.

Diversification Based on Business Sector

Common stocks can be divided into ten sectors: Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunication Services, and Utilities. Most large mutual fund families will have a fund which specializes in each of these sectors. Each of the sectors performs differently depending upon the stage of the economic cycle. Some will perform well when the economy is coming out of recession, while others perform best when the economy is slowing down.

By investing in a number of Sector funds, the investor can choose sectors based on the current point in the economic cycle. Then, when it appears the cycle is about to start changing, the investor can move reallocate assets into sectors that do well in the upcoming cycle.

Again, such a portfolio of stocks funds should be tempered by investing in one or two bond funds.

Putting Investment Style Funds and Sector Funds Together

The best approach is to invest over half of the investment portfolio in diversified large cap and small cap mutual funds. Up to 30% of the assets can then be invested in Bond funds. These funds will be maintained through the various economic cycles. Then, the investor can purchase Sector funds with 20% – 30% of his assets. These sector funds should be rotated periodically as the economic cycles change.

This approach of combining Style funds and Sector funds will allow the investor to stay invested at all times in large diversified portfolios while adding the extra investment performance which should come from the specialty Sector funds.

The investor would not want to use only Sector funds in case the Sector should not perform as expected. These funds will have wider performance swings than large diversified portfolios. Similarly, the investor would not want all assets only in the diversified style funds. While this may be safer way to go, these funds may not provide the necessary investment performance to grow the portfolio sufficiently.

Investors should read and keep on reading about Style funds, Sector funds, and how each performs during the various changing business cycles. Once the basics are known, the investor can construct his portfolio which should perform well during the changing markets.