Playing it safe can kill your portfolio

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In case you haven't noticed, the S&P 500 Index ($INX) has averaged less than 2% a year this decade -- more proof that a portfolio that just matches the market isn't good enough if you're trying to fund a child's education or your retirement.

You wouldn't put most of your money into a savings account with that sort of return. Yet many of us do about the same with the core of our portfolio -- the largest portion.

Indeed, many investors think that the core is too important to risk losing, so they protect it by keeping it in "risk-free" investments, such as money-market accounts, that barely keep up with inflation.

This is a great strategy if your primary goal is not to lose money. But if your portfolio is not already big enough to meet your financial goals, investing in "risk-free" securities pretty much guarantees that it never will be.

Don't settle for average

So if you want your portfolio to really grow, you need to invest in stocks. If you're a regular user of this site, you probably know that.

One common approach to investing in stocks is through a fund that mimics a market benchmark such as the S&P 500. Advocates of this approach say that the S&P 500 Index has averaged about 11% a year over the past 70 years, so they feel comfortable using it for planning purposes. But after the first nearly seven years of this decade, those who invested the core of their portfolio in an S&P 500 Index fund are now far behind plan.

It's time to consider alternatives for your core.

Favor proven money pros

The acid test of whether a mutual fund should be considered for the core of your portfolio is whether the fund's manager has a track record of beating the S&P 500 after all fees.

Let's be clear that we are talking about the manager's track record, not the fund's. When you invest in a mutual fund, the single most important factor in determining your returns is the skill of the current manager. If the manager took the helm two years ago, then only the last two years of the mutual fund's track record are relevant. Whoever was managing the fund before that is long gone and will have no impact on your returns.

People disagree about how long a track record is needed to assess a manager. But few would argue that you could do it with less than a five-year track record.

According to Morningstar, out of 10,929 domestic equity mutual funds, only 3,447 managers have been at the helm for at least five years. In other words, almost 70% of mutual funds should not be considered for your core portfolio because the manager has simply not been there long enough to prove his or her skill.

Of the 3,447 funds where the manager has been at the helm for the last five years, 2,422 (about 70%) beat the S&P 500 over that period! This is somewhat surprising because I frequently hear that the S&P 500 index beats 60% to 70% of all mutual funds. Turns out most of the funds that the S&P 500 beat over the last five years are those with relatively new and unproven managers.

Many of the 2,422 funds that beat the S&P 500 are just different share classes of the same portfolio. Limiting the set to "Distinct Portfolios Only" gets us down to 889 funds.

Go with the broad funds

For the core of a portfolio, we don't want a single-sector fund or one that makes big bets. These kinds of funds require you to closely monitor them to decide when to invest and when to get out of their specialty area. As a result, they may be appropriate for the more adventurous "explore" portion of your portfolio, but not for the core. Eliminating specialty funds and funds that put more than 30% of their portfolio in their top 10 holdings gets us down to 461 funds.

Since the core is the majority of most people's portfolio, the ability to protect capital in a bear market is an extremely important quality to find in a manager. Screening the remaining 461 funds for those that Morningstar ranked in the top 25% in bear markets narrows the field to 23 funds.

Finally, since you are doing your own research, you shouldn't have to pay a load. Of the 23 remaining funds, 17 are no-load funds.

The managers of all these funds have a five-year track record of beating the S&P 500 (after all fees) with a diversified portfolio without making big bets while protecting the downside in bear markets. I think that makes them worthy of consideration as a core holding.

If you would like to see the list of all 17 funds, click here to send me an e-mail. I'll be happy to send it to you. I am proud to say that the mutual fund I manage is among them!