Of all the decisions you make when investing in mutual funds, none is more important than how you divide your money among equity, bond and money-market funds.
When you split your portfolio among equity funds for growth (and possibly income), bond funds for income, and money-market funds for income and stability of principal, you have a major impact on both its rate of return and level of risk.
Before you select the funds themselves, you need to have an idea of what mix would be appropriate for you. It depends on such factors as your income requirements, the number of years you plan to be invested, and your ability to tolerate short-run volatility.
Of course, you may want to adjust your mix occasionally as marketconditions change. In some years, such as 1989 and 1991 (to date), stocks outperform bonds and cash equivalents. In other years -- most recently in 1986 -- bonds outperform stocks and cash. And in still other years -- such as 1990 -- even low-yielding cash does best.
If, however, you feel uneasy about relying on your own decisions, consider a fund whose manager makes the decisions for you.
Such funds, diversified across the three asset classes and known as asset allocation funds, appeared in the mid-1980s -- long after such techniques were introduced in pension fund management. And they have multiplied since the 1987 crash.
Asset allocation funds have more flexible policies than traditional balanced funds, which must be invested at least 25 percent in bonds and which don't reallocate assets frequently.
By aiming at optimum blends of securities, asset allocation funds should show respectable -- but not the highest -- total returns over time and do so with less volatility than general equity funds.
Has the theory worked? Because most have only been around a few years -- 6-year-old Carnegie-Cappiello Total Return and IDS ManagedRetirement are among the oldest -- their performance records aren't long enough to offer a meaningful answer.
Lacking long-run data, you need to study prospectuses, reports and other information. They can help you determine whose policies are most compatible with your investment goals and whose brief records seem most promising.
When you look at the table, which lists 1991's performance leaders among the larger asset allocation funds, you can quickly see differences in their behavior. Rankings can change from year to year. Differences in performance occur in three ways: their normal asset allocation, their securities selections and the degree to which -- and skill with which -- they can and do reallocate.
Funds that did the best in 1989 and (thus far) in 1991, two good years for common stocks, have been heavily committed to equities. Greater diversification or skillful reallocation paid off for other funds last year, an off-year for stocks.
Gordon Fines, who managed the IDS fund from its inception until last April, had no less than 75 percent to 80 percent of its assets in stocks. He tried to reduce the fund's exposure to stock market risk by being diversified among many companies.
Frank A. Cappiello, manager of the Carnegie-Cappiello funds, has relied on a combination of stocks and bonds that are convertible into stocks. Lately, he has been about 65 percent in stocks and 25 percent in convertibles -- allocations reflecting his "bullish bias," he says. In anticipation of lower interest rates, Mr. Cappiello has been loading up on interest-sensitive utility stocks; they now account for about one-third of his equity assets.
Robert Beckwitt, manager of Fidelity Asset Manager since its inception at the end of 1988, has had to operate within certain guidelines: no less than 10 percent or more than 50 percent in stocks, no less than 20 percent or more than 60 percent in bonds, no more than 20 percent "junk bonds."
In allocating the assets of Vanguard Asset Allocation Fund, Mellon Capital Management Corp. is not bound by asset limits. Using a math model its principals developed in the mid-1970s, its computer recommends allocations after digesting projections of inflation rates and of long-term stock, bond and cash returns. The fund could go to 100 percent stocks; in fact, it has averaged 50 percent stocks and not exceeded 60 percent. When stocks do well, it lags the market; when stocks fall, bonds provide a cushion. The fund began this year at 60 percent stocks; it's now 60 percent in bonds.
In a leaflet promoting its Managed Assets Trust, Dean Witter claims: "Once you decide to buy shares of the trust, you may never have to make another investment decision."
That's probably claiming too much. But if you choose a well-managed asset allocation fund, you may not need to make many.