Rate Worries? No Worries With Right Strategy

The investment markets launched into a flurry of activity this week - lots of shifts from stocks to bonds then back again - as interest rates ticked higher.

Should mutual fund investors rethink their own investment strategies?

The Federal Reserve, as expected, bumped a key interest rate by one quarter of a percentage point Tuesday, prompting a change in investment strategy on some parts of Wall Street.

But if mutual fund investors have prepared their portfolios carefully, they are insulated against exactly the sort of volatility that has played out this week.

Asset allocation is the rallying cry for many mutual fund investors because it lets their portfolios absorb market swings.

Asset allocation means finding a mix of mutual funds to accommodate stocks, bonds, and cash. How much money goes to each, and to what kinds of stock funds and bond funds, depends on your goals.

But many experts say that getting the mix right literally determines the performance of your portfolio, shielding you from changing economic circumstances and meeting long-range goals.

"Every investor and saver should have an asset allocation plan," says Walter Updegrave, associate editor of Money Magazine.

The types of funds you hold and the proportion in which you hold them are the keys, he says.

Some experts suggest a simple plan, perhaps three to six different funds.

And some investors take the concept and run much further. Here at the Monitor, for example, one editor invests in 26 different mutual funds.

But that's a bit extreme.

As few as three funds can do the trick: an index fund (which aims to track a stock market index, usually the S&P 500) for stocks; a bond index fund; a money market fund for cash.

Or you could be more specific, usually with the stock funds.

If, for example, all your stock money belongs to an index fund, it will rise and fall with the US market.

So you might include a global fund, European or Asian, to protect against downswings in one market or the other.

You can refine this mix to a remarkable degree.

Most mutual fund families offer several models for asset allocation, depending on your goals. We'll show you one from Fidelity Investments, but note that fund families, want to sell you their own funds to fill out the mix.

Independent experts offer their own models. They also recommend ways to evaluate and buy funds from several families.

Discount broker Charles Schwab, for example, lets customers put funds from a variety of families into one account.

Fidelity offers five sample models, depending on how soon you'll need the money.

Model 1, less than two years. 100 percent in short term instruments such as money market funds.

Model 2, two to five years. If generating income ranks higher than preserving capital, 50 percent in bonds, 30 percent in money market funds, and 20 percent in stock funds.

Model 3, four years. This portfolio leans towards both income and growth: 50 percent stocks, 40 percent bonds, and 10 percent money market funds.

Model 4, at least seven years. This is for building wealth: 70 percent stocks, 25 percent bonds, and 5 percent money market funds.

Model 5, more than 10 years. This is an aggressive portfolio, built on the premise that stocks, in the long haul, outperform bonds: 100 percent stock funds.

Other planning models hinge more on investment styles than time frames: conservative, moderate risk, or aggressive - open to lots of risk.

Rebalance your accounts once a year, experts say, to make sure that you're sticking with your model. (A soaring stock market can quickly throw your percentages out of kilter, for example.)

Some funds try to simplify things: They allocate for you.

A balanced fund typically holds about 60 percent stocks and 40 percent bonds. An asset-allocation fund also blends stocks and bonds, but tends to change its mix more based on the short-term investment climate.

Some top-performing balanced funds are shown in the chart above. For comparison, the Standard & Poor's 500 stock index has returned a total of 82.45 percent over the past three years. While none of the funds in the chart beat that, they are considered less risky.

Flag Investors Value Builder currently has a portfolio of 68 percent stocks, 23 percent bonds, 5 percent cash and 4 percent convertible securities.

Vanguard Wellington has a current mix of 63 percent stocks, 37 percent bonds.