Portfolio Design 101

Question of the week:I'm just starting to save for retirement and am doing a lot of research to find the best possible mutual funds. What are your recommendations? --G.B.

Dear G.B.,

Your enthusiasm is commendable, but you're really putting the cart before the horse here. Choosing your mutual funds before you've designed your portfolio is like building a house and shopping for the wallpaper before you even have the blueprints.

The important question is actually not which mutual funds you should buy, but what kind of portfolio you want to build. Once you know that, it will be easy to choose the right funds.

You see, contrary to popular wisdom, most of your investment returns over the long run actually have little to do with your individual investment choices. Instead, academic studies tell us that most investment returns are largely determined by your asset allocation--the different types of investments and the proportion of each investment type in your portfolio.

In other words, a portfolio consisting of 100 percent stocks will perform very differently from a portfolio made up of 80 percent bonds and 20 percent cash. This makes your asset allocation much more important to your long-term investing success than the specific funds you choose.

We recently asked members of the Armchair Millionaire community about how they build their portfolios, and heard several detailed descriptions. Here's one:

"My portfolio is in stocks, heavily weighted toward small caps. My Roth IRA is entirely in small caps, while my brokerage account is mixed … and my 401(k) is 20 percent large cap value, 20 percent large cap growth, 30 percent small caps, 20 percent international and 10 percent employer stock." --Doug

While Doug has obviously done a lot of thinking about his portfolio design, your own does not need to be so complicated, particularly since you're just getting started. My guide will give you a basic overview of using asset allocation to build the best possible portfolio for your needs.

The Armchair Millionaire Guide to Designing a Great Portfolio

• Step 1. Choose your asset classes. An asset class is a set of investments that share the same broad risk and return characteristics. The three we think of most commonly are stocks, bonds (also called fixed income) and cash (which includes money you keep in CDs, a money market account, or in U.S. Treasury bills). Most people who are investing for a goal that is many years away--such as for retirement--will generally want to invest primarily in stocks because they offer the best returns over time. For shorter-term goals, you can mix in bonds and cash, which generally give you a lower return, but also less risk.
• Step 2. Choose your sub-asset classes. Sub-asset classes are groups within each asset class that share a narrower set of risk and return characteristics. The most important sub-asset classes within the stocks asset class include U.S. large cap stocks, U.S. small cap stocks and international stocks. It's important to diversify across all three of these sub-asset classes in order to get the highest returns while minimizing your risk. The allocation I've chosen for my own portfolio is one-third for each of the three.
• Step 3. Choose your funds. Now you're ready to pick the mutual funds that will fit into the asset allocation that you've chosen. I highly recommend using index funds, which track the stocks of sub-asset classes. An S&P 500 index fund, for example, is composed of U.S. large cap stocks. A Russell 2000 fund is composed of U.S. small cap stocks. Because you always know which sub-asset classes index funds invest in, they make it very easy to stick with your chosen asset allocation.
• Step 4. Put it into action. Once you know the funds you want to buy, the rest is easy. Simply contact a broker or consult with a financial advisor to open an account and purchase the funds. Or, you can usually buy your funds directly from the fund company.

THE BOTTOM LINE: Wall Street would love us to think that the key to investing success is simply buying the latest hot mutual fund. But what it really takes is using asset allocation to design a portfolio that makes sense for you, and then buying--and holding--the mutual funds that are right for that portfolio.