Mutual Funds & Asset Allocation


Do you remember our discussion about asset allocation? Asset allocation is the process of dividing the money in your investment portfolio among stocks, bonds, and cash which are also called asset classes. For a review of asset allocation, check my Asset Allocation = Investment Chili blog.

As you allocate funds between the three asset classes, you may choose to invest in mutual funds or exchange-traded funds for each asset class. (See these blogs: Mutual Funds and Exchange-Traded Funds.) On the other hand, you might want to buy just one fund whose manager allocates between the asset classes for you. Although there are a handful of asset allocation ETFs, there are far more choices in the mutual fund universe. An asset allocation mutual fund makes sense, especially if you are a busy professional, have children, or just have other priorities for your time. Choosing one fund may not only save you time but will also spread your investment dollars further. You have the benefit of a professional manager and fewer investments to monitor.

Asset Allocation Mutual Funds

There are two varieties of asset allocation mutual funds. One keeps a relatively constant stock-to-bond mix: for example, 70% stock and 30% bonds. Those are called balanced mutual funds. The other type changes the allocation to add more bonds and reduce stock as you grow closer to the need for money, such as for higher education or retirement. The latter are called target date mutual funds. Both are common options in company retirement plans.

Balanced Mutual Funds

Imagine you buy a balanced asset allocation mutual fund that targets 70% stock and 30% bonds. After your purchase, the price of stocks in general moves higher while bond prices stay the same. Due to the appreciation of the price of stock, over time, that portfolio will have more than 70% in stock and less than 30% in bonds. When that happens, the manager might sell stock, buy bonds, or do both to rebalance the mix to stay roughly 70/30. The fund’s purpose, in this case, to provide a mix of 70% stock and 30% bonds, is a key driver of changes to the portfolio. Of course, the manager is also trying to maximize the fund’s return with the investments she chooses.

The manager of a balanced asset allocation mutual fund could select individual stocks and bonds to compose the portfolio, but she might prefer index or actively managed mutual funds or ETFs. (The differences between active and passive management are discussed in the Mutual Funds blog.) If the manager uses other mutual funds or ETFs, it is called a fund of funds (her fund contains other mutual funds and ETFs). In any case, you will get a diversity of stock and bonds with just one investment.

Some balanced allocation mutual funds have names that sound like risk tolerance descriptions: conservative, moderate, or aggressive. (Risk tolerance is discussed in The Key to Investing – Know Yourself blog.) Some may just be called “balanced,” and it is up to you to research the allocation of stocks and bonds.

Target Date Mutual Funds

In addition to balanced funds, there are also mutual funds that target a specific date when you will need your money—the year you enter college, for example. Issuers of this type of mutual fund usually offer target dates in five-year increments: 2025, 2030, 2035, 2040, etc. These funds also mix stocks and bonds. The further into the future a target date may be, the more stock the manager will typically put in the portfolio to get a higher potential return. Gradually, as the target date gets closer and closer, she will decrease the amount of stock and add more bonds and cash. Why? Because as you get closer to your retirement date or the date you will enter college or tech school, you want less volatility, plus you also need liquidity. You are going to start to spend your money and you are counting on your investment to pay for retirement or education expenses. Think of it this way: when you are young, you may be comfortable with more risk, but as you age, a more conservative allocation may be appropriate (more bonds).

For most people, retirement lasts many more years than college, and therefore the need for money from your investments lasts longer. To ensure that you have enough money to last your lifetime, you want your investments to continue to grow. It makes sense to continue to hold stock in your portfolio even after you reach your retirement date. Otherwise, inflation will reduce your purchasing power. The percentage to keep in stock depends on how much income you need from your investments in addition to other sources of income you may have, such as social security and pensions, and what other financial resources you have in addition to your investments. Recent research supports a need for a higher allocation to stock longer into retirement, especially with lengthening lifespans.

A one-and-done, asset allocation mutual fund option is a good starting point for a new investor. If you do not want to spend time reviewing possible investment choices or have a limited amount of money to invest, this would be an easy way to get started. You could base your choice on the target date that you will need your money, or you could match your risk tolerance. There are fewer decisions and less to monitor.

~Beverly J Bowers, CFP®


Legal Notice: This document is intended to be informational only. Beverly Bowers does not render legal, accounting, or tax advice. Please consult the appropriate legal, accounting, or tax advisor if you require such advice. The opinions expressed in this report are subject to change without notice. The information in this report is from sources believed to be reliable but are not guaranteed to be accurate or complete. All publication rights reserved. Use of this material is subject to the Copyright restrictions described on BevBowers.com.
Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark and the CERTIFIED FINANCIAL PLANNER™ certification mark in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.