The eight rules for assembling a fund portfolio. By Steven Goldberg, Contributing Columnist March 31, 2006 Scott and Heather Connell won't retire for three decades. But the Delray Beach, Fla., couple are already preparing for life after work. They contribute the maximum to their 401(k) plans and sock away money in taxable accounts. "My father instilled in me the importance of saving and investing," says Scott, 30. "It’s vital. Everyone wants to retire, but so many people never map out how to get there. We’re starting young because we want to make sure we have enough to live well."So how do you assemble and maintain a mutual fund portfolio? We’ve distilled the task into eight rules. 1. Don’t chase winners Suppose you had decided on the first day of 2000 to invest $10,000 in each of the five best-performing funds of the preceding five years. The idea would have been tempting -- on average, the fabulous five funds had earned an annualized 53%. But the next five years told a different story. Those same funds lost 61% of their asset value. In other words, your $50,000 investment would have shrunk to $19,695. Past performance does matter. But in a vacuum, chasing winners is as dangerous as day trading. Not surprisingly, all five of the top-performing funds at the end of 1999 were technology sector funds. And sector funds belong at the edges of a portfolio, not at its heart. Advertisement 2. Spread your risk "In ancient times, when the crops were harvested, they shipped them in many different boats," says Jim Reardon, a financial planner in Topeka, Kan. By the same token, to build a solid investment plan, you need to diversify. Roughly half of the money you have targeted for stocks belongs in funds that specialize in large companies -- those that are household names. Among large companies, half of the money should be in a fund specializing in growth stocks -- those with fast-growing earnings -- and half in a fund that buys undervalued stocks that are currently out of favor. Technology firms exemplify growth stocks, and financial and industrial companies epitomize undervalued stocks. Put a quarter of your stock money into a foreign fund, preferably one that invests some of its assets in emerging markets, such as China. Although half of the world's stock market value is outside the U.S., most people don't invest enough money abroad. European stocks are cheaper than U.S. stocks, and Asian companies are growing faster. What's more, foreign stocks have beaten U.S. stocks for four straight years. Invest the last quarter of your stock money in a fund (or funds) that specializes in stocks of small companies. This lets you take advantage of their higher growth rate. Over the long haul, small-company stocks have returned about two percentage points more per year than their larger brethren. For optimal diversification, you'll want two small-company funds -- one that buys growth stocks and another that buys value stocks -- or one fund that buys both. Advertisement 3. Learn how funds differ When you pick your funds, be sure to rate them against other funds that fish in the same waters. Don't expect a value fund and a growth fund to have similar track records. Only by comparing funds with their true peers will you make superior choices. Why bother with all different kinds of funds? Because they don’t move in lock step the way those ill-fated technology sector funds did. When stocks of small companies are humming, large companies often languish. Growth stocks and value stocks also counterbalance each other, as do U.S. and foreign stocks. Case in point: The average fund that invests in stocks of large, fast-growing companies has lost money during the past five years. Over those same five years, funds investing in undervalued stocks of small companies have returned an annualized 14%, on average. Will the same types of funds prevail the next five years? History suggests not. Like a pendulum, the market eventually swings back the way it came. Owning a mix of funds smoothes out the ups and downs in your investments -- without sacrificing one iota of return. You can profit from the pendulum swings. Here's how: At the end of each year, tote up how much you have in each kind of fund. Target new money to the funds that have done poorly. Better yet, rebalance your portfolio by selling some of the winning funds and putting the proceeds into the laggards, so each fund ends up with the same percentage of money it started with the year before. Rebalancing takes guts -- it's hard to reward losers -- but it works. Advertisement 4. Steady your nerves Stocks often bounce around like a roomful of toddlers. It's no wonder many people grow leery of them. But investing too little in stocks is a mistake. Over the long haul, stocks' volatility levels off. Indeed, they have been the surest route to wealth for more than a century. Stocks behave erratically over the short term -- no question. In their worst year since 1926, stocks plunged 43%; in their best, they gained 54%. But look at the calming effects of time. Over rolling ten-year periods (such as 1930–39, 1931–40 and so on), including the Great Depression, stocks have never lost more than an annualized 1%. The more you know about stocks, the more comfortable you'll become with them. Over five-year periods, stocks have made money 90% of the time, as measured by Standard Poor’s 500-stock index. And they have beaten bonds and cash (money-markets, CDs and Treasury bills) in about 80% of five-year periods. Over 20-year periods, stocks have never lost money. And they have always earned more than bonds and cash. Stocks have returned more than an annualized 10% since 1926. That compares with 5% for bonds and 3% for cash, according to research firm Ibbotson Associates. Inflation, moreover, wreaks havoc with "safe" investments, such as bonds and cash. With inflation averaging 3% since 1926, your real, after-inflation return drops to a puny 2% from bonds and zero from cash. But stocks have returned an annualized 7% after inflation. (At 2%, it takes 36 years for your money to double. At 7%, it will double in just over ten years.) Because of stocks' superior returns, long-term investors should put as much as they can stand in stock funds -- and hang on. Advertisement That's easier said than done. "Most investors have a real time horizon of 20 years or more but an emotional time horizon of about 30 seconds," says Harold Evensky, a financial planner in Coral Gables, Fla. But here's the silver lining: If you lived through the 2000–02 bear market, in which the SP 500 lost 47% of its value, you've taken and passed a real-life risk-tolerance test. You have a terrific idea of what you're likely to do the next time the market heads south. You may well do better. Most bear markets inflict less pain than the last one. On average, stocks lose 30% of their value in a bear market -- and bear markets occur about once every five years. As you become a more experienced investor, you usually learn to endure short-term reverses better. But no matter what the numbers tell you, don't put more money into stocks and stock funds than you can handle. You need to be able to sustain a temporary loss of 30% or more without bailing out at the bottom. 5. Don't jump in and out In other words, don't try to time the market. Sure, pinpointing the right times to buy and sell stocks would make you wealthy in short order. But the record shows that few professionals have called market turns consistently enough to provide better returns than they would have had by simply buying and holding. You usually won't know when a bear market is beginning or ending until long after the fact. The authoritative Hulbert Financial Digest has tracked investment newsletters for 25 years. During that time, only a small percentage of the newsletters have added any value through their market-timing advice. Many more have subtracted value. Predicting which newsletters will provide good timing advice in the future is close to impossible. 6. Make a money friend Emotions play a huge role because investing decisions involve your gut as much as your brain. So find someone to help you think straight when the market turns sour. A spouse can make a great money friend. After all, good decisions will benefit both of you. If your spouse isn't interested, seek out a friend. And if you can't identify the right person, you may want to hire a financial adviser. "Coaching people through some of the difficult times is one of the most important things we do," says Kirk Kinder, a fee-only financial planner in Clearwater, Fla. "Most individual investors don't have the discipline to stay with investments." Most people invest more wisely after talking with someone they trust and respect. Yet many consider such discussions taboo. Don't make that mistake. Warren Buffett, the greatest investor of our era, has talked with Charlie Munger, his alter ego and sounding board, for more than 45 years. Most professional money managers discuss every decision with colleagues before they take action. You, too, can profit from having someone to talk to about your investments. Another important reason to have someone to talk with: The media bombards you with conflicting investment information. Most of the information is worse than useless. Indeed, the media and market gurus almost always become the gloomiest after the market sells off dramatically. Stick with one or two trusted sources of information, and ignore the rest. 7. Do nothing Investing takes work. But once you've picked your funds and built your portfolio, walk away and ignore them. Do something else. Checking daily or even monthly fund prices is a waste of time. One of the hardest things -- yet one of the most vital -- is to do nothing. Sit back and observe when the market falls 30%. Hold on while a fund suffers through an inevitable rotten year or two. Watch as funds you don't own sizzle. Patience is probably the most important trait an investor needs. You likely made the right investment decisions, so give them time to prove themselves. 8. Be a bit above average Munger, Buffett's business partner, likes to cite a survey of Swedish drivers, 90% of whom rated themselves as "above average" behind the wheel. Obviously, many respondents overestimated their abilities. When investing, Americans display the same level of self-assurance, Munger maintains. Research shows that many investors tend toward overconfidence. Not surprisingly, the cockiest tend to trade the most frequently and tend to get inferior returns. Be realistic. If you invest in funds, you'll do well to beat the market averages by one or two percentage points annually over the long haul. The stock market is tough and competitive, and even the most talented fund managers don't fare much better over the course of their careers. If building and monitoring funds seems like a lot of work for a single percentage point, see Real Simple Investing. You'll find several low-maintenance ways to match the market averages. But beating the averages by a single percentage point a year can, over time, make a huge difference in your net worth. Suppose you invest $100,000 in the stock market and earn 10% a year. After ten years, you'll have a healthy $260,000. But if you make 11% annually over those same ten years, you'll net $25,000 more -- or 25% extra on your original investment.