Mutual Fund Selection
Assembling Your Portfolio

Your final mutual fund selection will determine the efficiency of your portfolio. Having completed your screening and selecting two or three satisfactory mutual funds from each asset class in your universe, you can now evaluate the mutual funds as constituents of a portfolio to identify those that work best as a group to provide you the best risk-to-return ratio consistent with your risk profile.

In theory, your mutual fund selection should optimize your portfolio for the set of mutual funds that will comprise your portfolio. However, besides the fact that most of you probably do not have the skills, knowledge, and resources required to do this, many of you might not be comfortable with the results rendered by the optimization process, as that often involves short selling and buying on margin. Or you may simply prefer to weight your portfolio heavily toward those assets that you consider to be more conventional, although that would result in a sub optimal portfolio.

It's important for you to be comfortable with your portfolio and you need to establish an acceptable balance between comfort and economic utility, similar to establishing a comfortable balance between risk and return. As you gain experience as an investor, you will probably find that you are comfortable with more risk and with assets beyond the universe of domestic large-cap stocks and high-grade domestic bonds that so many people consider to be the universe of conventional assets and expand your mutual fund selection accordingly. So we'll explore some options besides optimization.

You may want to base your weightings on each asset's percent of the aggregate market capitalization of your universe. This would result in your owning the market portfolio, which in theory would be the optimal risky portfolio for your universe. However, its level of risk may be too little or too great for your risk tolerance. Otherwise it would be optimal. You can lower the risk by allocating a portion of your capital to cash. Raising the risk in this scenario is going to be a shot in the dark unless you're willing to buy more of the market portfolio on margin or take the time to establish the efficient frontier, otherwise you won't know if the blend you formulate to get the desired level of risk is the optimal blend at that level of risk, i.e., it may not be efficient.

Or you may decide you want a portion of your mutual fund selection to make up the bulk of your portfolio and distribute the rest of your money over the remainder of the funds. Of course, this methods is not likely to produce an efficient portfolio. Having a portfolio with a solid core of "conventional" assets is a very popular strategy, although it is apt to result in owning a portfolio that is either riskier than necessary or, if it's heavily weighted toward bonds, has a relatively low rate of return, thus making it difficult to achieve your goals.

Identifying a near-optimal portfolio by testing various blends of the mutual funds you selected for your universe is another means of determining the allocation of your capital. This method provides a means of finding a blend of your mutual fund selection with suitable risk-to-return characteristics while staying within the bounds of conventionality with which you're comfortable.

A portfolio that is efficient by mean-variance criteria may be your best bet. The efficient frontier offers you a continuum of portfolios that are mean-variance efficient but avoids buying on margin, which would be required beyond a certain level of risk with an optimized portfolio. And you can simply avoid short selling by making it a constraint in your model. However, at levels of risk above the point of tangency of the margin CAL, the efficient frontier is less efficient than the margin CAL.

One last thought. Don't forget cash or cash equivalents, i.e., the risk-free asset. Cash will damp the gyrations of your portfolio but produce a correspondingly lower expected rate of return.

Everyone needs to keep some cash on hand for a rainy day. As cash is a financial asset, that rainy-day money, cash reserve or the balance below which you never let your checking account balance fall should be factored into your portfolio. Also, if the blend of mutual funds you select results in a level of risk that is greater than you desire, allocate enough of your capital to cash to bring the risk of your portfolio down to the desired level.

Including a money market fund in your mutual fund selection is a good way to satisfy the cash component of your portfolio. It's best if all or most of your cash is in a money market mutual fund. After you pay your bills each month, put your excess cash in the money market fund. If you need money to pay some bills, transfer what you need from the money market fund to your checking account.

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