A Suze Orman exclusive

Portfolio Focus
Like the menu at your favorite Chinese restaurant, there are a multitude of fund dishes you can choose from. While funds can own stocks, bonds, or both, I am just going to concentrate on the world of stock funds for now. When you are investing for 20, 30, or more years down the line, your money belongs in stocks, not bonds. Besides, as I explain below, I am not a big fan of bonds inside of mutual funds.

Each mutual fund has two major personality traits: the size of the stocks it owns, and the investment philosophy of the manager.

Let’s deal with the size question first. Stocks within funds come in three broad sizes: large-cap, mid-cap, and small-cap. A large-cap stock is a big established company. Think of it as a mature adult. A small-cap stock is a young kid; it tends to be a newer company that still has considerable growing up to do. If the company is successful, those growth spurts can translate into big stock gains. But there is no guarantee that a small-cap fund will be able to grow into a large-cap. That’s the trade-off: you tend to have great potential gains with a small-cap, but you also have to stomach more risk than if you were invested in established large-cap stocks. And mid-caps are the young adults; they aren’t a kid, but they also aren’t a fully grown large-cap either. So you have some of the growth potential of a small-cap, with a bit more of the stability of a large-cap.

Now in addition to those size issues, we have to deal with the manager’s investment style. Again, we’ve got three broad choices: growth, value, and blend. A growth manager invests in stocks that are expected to have strong earnings growth. A value manager invests in stocks that he or she believes are selling below their value. With a growth stock the bet is that it will go from a decent price to a great price. With a value stock you are buying when the price is excellent (meaning low) with the expectation it therefore should rise strongly, even if probably not to the exceptional heights you might get with a successful growth stock. No surprise that growth stocks tend to be more volatile than value stocks, given the higher expectations. Which brings us to blend managers, who strive to achieve a balance between possibility and risk by blending growth and value investments.

Each fund is assigned to a category based on the size of its securities and the manager’s investment style. There are large-cap growth funds, large-cap value funds, large-cap blend funds, mid-cap growth funds, mid-cap value funds, etc. One thing to be aware of is that not all mid-cap funds own only mid-cap issues; quite often they own a mix of large, small, and mid-cap issues, so that their average market cap falls in the mid-cap category. For example, the Vanguard Extended Market index fund has 11 percent in large-cap issues, slightly less than 40 percent in small-cap issues, and about 50 percent in mid-cap. The net result is that Morningstar, the mutual fund data company that supplies info to Yahoo, categorizes the fund as a mid-cap blend fund.

How to sort through all that info, without tearing your hair out? Don’t worry, there’s no rule that says you must own one type of every fund. I recommend that large-cap funds should be the core of your fund portfolio. A fund like the Vanguard Total Stock Market index has about 80 percent of its assets in large-caps. Or if you want a bit more growth potential, the Vanguard Extended Market that I just mentioned tilts more toward smaller and mid-size firms.

And please don’t think that more is better with funds. If you have one or two index funds, or you pick a few different types of actively managed funds, that’s all you need. The goal is to make sure that each fund you own complements the other, rather than being carbon copies. For example, if you own five funds and all five are large-cap growth stocks you do not have a smartly diversified portfolio. It’s like having a closet full of basically the same outfit.

Once you have your core investments in place, it’s up to you if you want to add some complementary funds. I think it can be smart to invest 15 percent or so of your fund assets in one that specializes in foreign stocks. We live in a global economy, so it makes sense to have exposure to investing opportunities outside of the U.S. Now, that said, it’s also important to realize that if you own a large-cap fund you already have some foreign exposure, since many of the largest U.S. firms make a chunk of their money from foreign sales and operations. Still, adding a pure foreign fund can be a nice complement to your fund portfolio.