Get Ready for the Next Big Thrill

you have some idea of whether you are Bold Bart or Nervous Nellie, you can begin the process of constructing your mutual fund portfolio. David Kathman, a fund analyst at Morningstar, says you should first determine the risk of various fund categories.

“Risk is often equated with volatility,” says Kathman, “and the most common way to measure the volatility of an investment is standard deviation.” In essence, standard deviation reflects historic swings in investment returns. The wider the swings, the greater the risk investors will face. So, historically, a large blend fund–a mix of large-company growth and value stocks–would provide far less risk than specialty funds, such as those that invest in precious metals. During the past five years, however, precious metals funds returned nearly 22% a year on average, twice as much as large blend funds. Therefore, risk-takers were rewarded.

A more audacious investor, then, might start off with a core holding of large-company domestic and international stock funds. Smaller-company funds, specialized sector funds, and emerging markets funds could be added, in search of higher returns. Fixed-income investments would be virtually nonexistent in his or her portfolio.

What about investors with very little taste for risk? “I’d recommend a large allocation to bond funds,” says Outlaw. All fixed-income investments–including those that hold low-rated j
unk bonds–tend to provide more safety than any stock fund category.

Once you’ve decided on your mix of fund categories, the next step is to pick funds within each class. Always focus on past performance, expense ratios, asset turnover ratios, and the tenure of fund managers, among other key elements. Another risk gauge: five- or 10-year returns.

Morningstar’s Kathman also suggests taking a critical view of portfolio diversification. For instance, a fund with 30 holdings might prove to be more volatile than a vehicle with 50 stocks.

One way to size up the best funds is to review our Moneywise 100 listing; we have taken into account all of the aforementioned factors. As a rule, however, evaluate risk for yourself before investing a single dollar to determine if a fund will provide the ups and downs of a rollercoaster ride or keep you on solid ground.

THE MONEYWISE 100