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Strategies to be Adopted to Avoid the pit fall in Mutual fund Portfolio Management

IndianMoney.com Research Team | Updated On Monday, November 17,2014, 02:38 PM

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Strategies to be Adopted to Avoid the pit fall in Mutual fund Portfolio Management

 

 

Following are the strategies that can be adopted to avoid the pit fall in Mutual fund Portfolio management.

1. No Strategy

This is perhaps the most common mistake in mutual fund investing. It never ends to be surprised by the large number of individuals who select specific mutual funds without giving any idea to an asset allocation strategy. Many investors may actually define and identify their investment objectives, but then miss out the next critical step in establishing a successful mutual fund portfolio-creating a detailed asset allocation strategy. Exclusive of a well-defined, appropriate asset allocation strategy that accurately reflects individual investment objectives and preferences (time horizon, return objectives, risk tolerance, etc), the selection of mutual funds is haphazard (messy) instead of a logical, clear-cut process.

With very few exceptions, the result of haphazard fund selection is inappropriate asset allocation, which in turn causes ineffective diversificationwith the final result being poor or mediocre portfolio performance. Ineffective diversification has both allocation and risk/reward characteristics which do not precisely represent the chosen investment objectives in a given portfolio. In particular, these characteristics may include over-weighting of fund categories, under-weighting of fund categories and/or inappropriate funds in the portfolio. Over-weighting and under-weighting of fund categories are significant percentage imbalances in allocation correspondingly, they account for additional and insufficient of a portfolio's assets. Inappropriate funds do not robust the chosen investment objectives and they are the "wrong" funds for a portfolio rather than allocation imbalances.

On the contrary, effective diversification is a straight result of an appropriate detailed asset allocation strategy that fits individual investment objectives and preferences. Effective diversification distributes investment assets among different fund categories to achieve both a variety of distinct risk/reward objectives and a reduction in overall risk. Appropriate in depth asset allocation not only eliminates unattractive characteristics of over-weighting, under-weighting and inappropriate funds, it perfectly matches fund categories and their percentage of portfolio assets to specified objectives -- in essence, it is the "blueprint" for suitable fund selection.

Establishing a successful mutual fund portfolio is a three-step process. The first step is identifying investment objectives and preferences, including portfolio amount, return objectives, time horizon and risk tolerance, second step are formulating a detailed asset allocation strategy by fund type category to reflect chosen objectives and the last step is suitable fund selection to match each category. The second step is the trickiest due to the abundance of asset allocation theories and strategies. Most asset allocation strategies fall into two groups, the first group is the one primarily treats risk as a stock/bond allocation, with risk tolerance changing the percentage of stock and bond funds and the other one is primarily a fund category allocation, with risk tolerance affecting the type of fund categories and their allocation percentages within a basic stock/bond allocation.

Apart from of which asset allocation method an investor prefers, the important note is clear that is to avoid the pitfalls of haphazard fund selection, develop a detailed asset allocation strategy which accurately represents your investment objectives and preferences.

2. Over- Weighting in High-Risk, Non-Diversified Funds

This error is a precise example of portfolio imbalance. A huge percentage of total portfolio assets are concentrated in funds with very high risk/reward characteristics, even if the fund types may actually reflect chosen investment objectives. The result is extreme unpredictability in the price movement of these funds which, in many instances, can cause disappointing portfolio performance because the very large percentage of risk does not justify the potential reward. In other terms, the risk is highly disproportionate to overall profit potential. Over-weighting can arise with any type of risk tolerance, although this specific type of over-weighting is more likely to be a problem in portfolios with aggressive risk tolerances.

A high-risk, non-diversified stock fund category includes domestic and foreign small-cap growth, emerging markets and sector funds. In bond categories, emerging market and assured high-yield funds are also high risk. These fund types can be appropriate in many portfolios, provided an investor sticks to the principles of effective diversification. That is the distinct risk or reward objectives within a variety of fund types and a reduction in overall portfolio risk.

Are there an acceptable percentage of high-risk, non-diversified funds to own in a portfolio? Most strategy recommend between 5-30% of total portfolio assets, depending upon the choices of aggressive, moderate or conservative risk tolerances and growth, balance or income-oriented return objectives. The solution is to treat high risk, non-diversified mutual funds as a suitable portfolio supplement without dramatically increasing overall risk.

3. Duplication of Fund Categories

This type of fault is a case of inefficient diversification and occurs when an investor has two (or more) funds with identical objectives. For example, owning two small-cap growth funds, two large-cap growth funds and one intermediate corporate bond fund in a five-fund portfolio is inefficient diversification due to the replication of fund objectives in the small and large-cap growth categories. In this type of arrangement they lack the array of distinct risk or reward characteristics of ideal diversification. To avoid replication, it is most excellent to represent a fund category with just one fund.

The essential familiar factor in avoiding these three common mistakes is appropriate detailed asset allocation. It provides effective diversification and eliminates the troubles associated with haphazard fund selection. It is the explanation in establishing a successful mutual fund portfolio.

 

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IndianMoney.com Research Team

The research team at IndianMoney.com comprises of certified and experienced professionals who share the company's vision to make every Indian financially literate by equipping every Indian with right and unbiased advice. IndianMoney.com research team provides newsletters, articles, videos and FAQs on various financial products and concepts only to help you make wise financial decisions.

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