Creating a winning portfolio

Try this simple test. Pull out your latest brokerage statement. Review all the mutual funds on the list. Do you know exactly how each one fits into your investment plan? Are you satisfied that it represents the precise weighting you want?

If you can answer yes to both questions, you probably don’t need to read any further. But the odds are that your response to one or both queries is “no”. In that case, you need this information. It may be worth thousands of dollars to you in the years to come.

Most mutual fund accounts grow like Topsy. They lack any coherent rationale. Your financial advisor says XYZ fund looks good, so you add it. You read that ABC fund is a hot performer so you buy some units. Someone says bond funds should do well in the coming months so you get one. The result is a mess of unrelated funds that underperforms for reasons you don’t fully understand.

You need to make a fundamental change in the way you choose your funds. Your goal should be to create the perfect mutual fund portfolio for your needs. It’s not as hard as you might think. You just need to understand what you’re trying to achieve and then have the discipline to do it.&l;/>

The ideal fund portfolio should achieve the following:

* Provide potential for steady growth at an average annual rate of at least 8 percent -10 percent annually over the long term.

* Limit downside risk in falling equity markets.

* Provide some currency protection.

* Be well-diversified by asset class, style, and geography.

* For non-registered portfolios, be tax-efficient.

You should review these criteria every time you consider a new fund for inclusion in your plan. If the fund doesn’t meet at least two of the objectives, it should be bypassed.

Let’s review each criterion in detail.

Growth potential. The biggest mistake many fund investors make is to succumb to greed. It’s the reason that many people got clobbered in the high tech crash. They saw the huge returns that tech-weighted funds scored in 1998-99 and overloaded their portfolios in that direction. At the same time, they underweighted underperforming value funds and fixed-income funds.

A reasonable average annual return over the long haul (say 10 years plus) is 8 percent – 10 percent annually. With careful management, 10 percent – 12 percent is achievable. If you aim higher than that, you will have to accept a degree of risk that will make most people uncomfortable.

Downside risk. If you feel that your fund portfolio suffered higher losses than you would have liked in the market tumble, then you may have built in too much risk. The answer is to rebalance your asset mix to put more emphasis on low-risk securities, such as money market funds, mortgage funds, bond funds, balanced funds, and value-oriented equity funds.

However, don’t go to the extreme of making your portfolio so safe that you reduce your return potential to less than 8 percent annually. Yes, you can bullet-proof your portfolio with ultra-secure funds, but in doing so you will compromise your returns. The key is to find the right balance.

Currency protection. There is no way of knowing where the loonie will go in the future. But we can say two things with certainty.

1) Our currency has been devalued by about one-third against the U.S. dollar in the past decade.

2) Every prediction that the loonie is about to rise to US$0.70 and higher has proven wrong to date.

Of course, all this could change. But if past trends continue, the Canadian dollar will gradually lose more ground against the greenback in the coming years.

That’s why every fund portfolio should contain some currency protection. This is not a case of speculation; it’s a matter of hedging against continued devaluation of the loonie.

This can be achieved by holding mutual funds that invest in U.S. dollar securities. These include U.S. equity funds, foreign bond funds, and U.S. dollar money market funds. Although many of the equity funds can be purchased in either Canadian or U.S. currency units, in fact it doesn’t matter which you choose. As long as the securities in the portfolio are denominated in U.S. dollars, you will get the benefit of any gain that currency makes against the loonie.

Of course, our dollar may turn around and start to rise, so you wouldn’t want to hold your entire portfolio in U.S. dollar funds (which you could, even in an RRSP). Decide on a U.S. dollar percentage that is appropriate for your plans (at least 25 percent is recommended) and be sure that you choose funds that will provide that.

(To be continued.)