The First Question is: ‘What Asset Classes?’, Not ‘Which Mutual Funds?’

One of the most common first questions to find on financial forums is “which of these funds should I invest in?” In some cases, these are folks who have freshly found themselves with 401(k) options for the first time. In other cases, the poster already has a wild mix of funds that overlap, thus providing a comforting illusion of diversification.

For those in the first category, the slate is clean but the question is still the wrong one. The first thing to ask is: “how should I divide my portfolio in terms of asset classes (and sub-classes)?” How finely an individual wants to ‘slice and dice’ is ultimately a personal choice, but most of the potential diversification comes in that very first choice: how much in stocks versus how much in bonds.

A rule of thumb and a place to start is: your age in bonds (with the rest in stocks). Ultimately, though, it is worth looking for model portfolio examples and doing research into the diversification benefits of international stocks (perhaps also: small and value) and differences between different types of bonds (e.g. Treasuries, TIPS, corporate and high yield).  Each additional ‘slice’ brings less incremental benefit, but another rule of thumb would be: any slice less than 5% of a total portfolio is probably not worth managing (so if you are slicing 30% in bonds into 7 different funds, you are probably going overboard).

For those in the second category, it is time to back up and evaluate the underlying assets in funds currently held. It is entirely intuitive and understandable that, faced with a series of promising-looking choices (The Ultra-Growth Super Stock Fund, The Highly-Diversified Fringe Market Fund and so forth) people choose what sounds good, or pick a series of funds expecting that to be the road to diversification.

Of course, many funds have holdings that overlap with one another – and many of the largest and most well-known funds often behave like large-cap stock indexes, providing little if any diversification benefit, and sometimes concentrating risk more than reducing it (See: Fidelity Magellan and Contra). Further complicating things, some funds also hold a mix of asset classes (Like: Vanguard Wellington and Wellesley) which can make it hard to even keep track of how much one has in stocks versus bonds (let alone domestic versus international, developed versus emerging, small versus large, value versus growth and so forth). There are ways to see the underlying assets (e.g. Morningstar’s X-Ray tool), but generally it is best to keep things simple so you can track your portfolio over time at a glance.

If this all sounds extremely complicated, well, it can be – so starting from scratch is often the way to go. Tune out recent performance, figure out your desired asset allocation, and assemble the best portfolio possible from the low-cost funds available. The one major exception: if your 401(k) absolutely lacks in a low-cost diversified option, you may need to reevaluate whether it is worth paying, for instance, a 5% front-end load for a simple bond index fund if there is a no-load, lower-expense active bond fund available.

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