Fund Strategies for the Long Haul

I am 25 and have been investing in mutual funds in my Roth IRA. I own three funds: (BEQGX Quote)American Century Equity Growth, (SSMGX Quote)Sit Small Cap Growth and (LLSCX Quote)Longleaf Partners Small-Cap. I was thinking that this would represent a decent diversification strategy since there is a large-cap, mid-cap and small-cap representation; however, I am down 25%, 25% and 5%, respectively. I thought that these funds were all reasonable picks within their group, basing my picks on Morningstar rating, expense ratio, and past performance.

Should I be looking to sell these funds due to their poor performance and rotate into something else?

-- Shane Borden

After two rotten years, the market continues to drop like a stone. And investors are trying to figure out how to avoid more double-digit losses.

Should I get out of the market and stuff my cash under the floorboards in the house? Should I dump all of my funds and buy new ones? Or do I need to add more bonds and cash to my portfolio?

These questions have become as common around the house as: Does the car need gas? Is your mother really coming to stay for two weeks?

Learning to cope with an overbearing mother-in-law might be impossible. But you can learn to live with your portfolio by making changes to it. Here's a simple checklist of things you can do to make investing bearable again.

Do Nothing

Being young does have its advantages. Besides having boundless amounts of energy and skin with no wrinkles, you have decades to make up any investment losses that you might suffer over a year or two.

Because you have years to invest, you can keep all of your money in stocks, assuming that you can live with short-term losses. Stocks, over the long haul, should outperform bonds. Yes, bonds are generally safer than stocks. But you're going to get paid more for taking on the risk of owning stocks.

From 1970 through 2001, a portfolio with 95% in large-cap, small-cap and international stocks and 5% in cash returned almost 12% annually. But if 60% of that portfolio was invested in cash and bonds, the average annual return was only 10%. If you're investing to make money, having more of your dough in stocks makes sense.

That said, you don't want to have all of your money in one, extremely risky mutual fund. You want to spread your assets around and own a mix of stock funds that won't all move in the same direction at the same time.

Reader Shane Borden, who sent in this question, is off to a solid start. Borden has money in a large-cap fund, which is a good proxy to the S&P 500 index. The S&P represents about three-quarters of the U.S. stock market. He also owns a mid-cap fund and a small-cap fund. (If you're worried about the actual funds you bought, you can read Beverly Goodman's recent piece on how to pick a good actively managed fund.)

"You're right on track diversifying by market capitalization," says Morningstar senior analyst Peter Di Teresa. "But you have to accept that if you're being aggressive then there are markets when you're going to get beat up."

And having all your money in stocks is being aggressive.

Mixing Value and Growth

If you want to temper some of the swings in your portfolio, you can mix value and growth funds -- with half of your money in growth and the other half in value.

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When one of these styles is out of favor, the other tends to be in favor. That's what you've seen in the market over the last couple of years. As of Friday's close, the average small-cap value fund is up 7.5% in the past 12 months. The average large-cap growth fund is down 22.6%.

Rather than betting on one style or another, you're better off investing in both and keeping that mix between large and small stocks. If you dump your faltering growth funds right now in favor of value funds that have better returns, you'll miss the upside when growth stocks make a comeback. And that will eventually happen.

Traveling Overseas

Adding an international stock fund might also reduce a portfolio's volatility and improve its returns. Yes, the international markets can and do move in tandem with the U.S. at times. But sometimes they don't.

This year, for example, the Japanese market is up. So is South Korea. By investing 10% or 20% of your money overseas, you'll add more diversification and also take advantage of the falling dollar.

Even if the foreign markets are completely flat, you can actually make money if their currencies continue to appreciate against the dollar. And any gains offset the losses you might continue to suffer in your U.S. stock funds.

Fixate on Fixed Income

If you really can't cope with losses in your portfolio, you can shift some of your money into cash and bonds. But if you can learn to live with the ups and downs of an all-stock portfolio, you probably don't need to do that.

If you're in your mid-20s or even mid-30s, you have all the time in the world to make back any short-term losses.