Creating a Retirement Portfolio Using Mutual Funds—Section 10

The price fluctuation or volatility of a portfolio can be reduced and its return possibly increased by combining a variety of mutual funds with different investment objectives. The first step in creating a retirement portfolio is to determine the allocation between stock based and bond based mutual funds. This is a function of your risk tolerance.

The portfolio of someone with a high risk tolerance (see section 8) would be weighted toward stock funds while the portfolio of someone with a low risk tolerance would be weighted towards bond funds.

For the stock portion of a portfolio, I typically recommend the use of small, medium and large cap funds that utilize both the growth and value style of investing (see section 4). I also include an international fund to obtain some diversification outside of the U.S.

While most stock based funds will move in the same direction as the primary market trend, they do not move in lockstep. Funds that invest in different size companies and who employ different investment styles perform relatively better or worse during different stages of the market cycle.

The problem, however, is that it is almost impossible to predict, with any accuracy, what stage in the market cycle we are in and what is coming next. By allocating your money between small, medium and large cap funds that employ both the growth and value style of investing, you do so with the understanding that each type of fund will eventually have its turn as market leader. Because not all of these funds move in the same direction, at the same time, and at the same speed, overall portfolio volatility is reduced. As one asset class or investment style is fading, another may be gaining momentum.

While this asset allocation method will reduce portfolio volatility, it will not protect you against market risk. If the market goes down far enough, for long enough, all types of stock based funds will lose value. Market risk can be controlled either by reducing your exposure to stock based investments or to exit the market entirely when it appears likely that the primary market trend has changed from up to down.

People investing for retirement often use bond funds as a relatively stable store of value for the portion of their portfolio that they don’t want to put at risk. Because safety is the primary consideration, U.S. Government or Investment Grade Corporate Bond funds are usually used. The main risk associated with these funds is interest rate risk where bond prices decrease when interest rates increase. (See section 7 and section 8). Interest rate risk can be controlled by investing in a combination of short, intermediate and long term bond funds.

The following are several sample portfolios ranging from aggressive to very conservative: