Asset allocation funds are mutual funds whose managers believe they can improve returns and/or reduce risk by switching back and forth among stocks, bonds and cash. Many in the investment industry promote these funds as a simple and profitable way to assemble a diversified portfolio.

But as is so often the case with such investment “products,” the results rarely live up to the hype.

The way asset allocation funds actually work

Asset allocation funds can shift their portfolio allocations between stocks, bonds and cash in order to capitalize on perceived investment opportunities in any one of those classes.

For example, if the managers are convinced the bond market is depressed and due for an upswing, they may invest heavily in fixed-income investments for a few months to take advantage of the change.

Some managers make their own judgments when choosing between stocks, bonds and cash. Others use what insiders call a “black box”&#8212a computer program that makes trading decisions based on a preselected set of rules for interpreting financial statistics.

Computer modelling gives this investment approach the appearance of being scientific and relatively foolproof. Yet it is just as likely to detract from a portfolio’s long-term return as it is to add to it.

How to Make Money with ETFs Learn everything you need to know in 'The ETF Investor's Handbook' for FREE from The Successful Investor. ETFs Guide for Canadian Investors: Find the best way to invest in ETFs with low fees, low risk & high satisfaction.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

Low interest rates not helping bond prices

Bond performance is inversely related to the rise and fall of interest rates; when rates fall, bond prices go up.

With interest rates at today’s low levels, bonds can’t go a lot higher than they are. In fact, bond prices will likely fall over the next few years as interest rates inevitably rise again. That means asset allocation funds would only earn interest income on their bonds. Instead of capital gains, their bond holdings could produce capital losses.

A strategy for generating profits with less risk

In place of heavily-advertised products like asset allocation funds, we continue to recommend that you invest in well-established, high-quality dividend-paying stocks, like those we recommend in our newsletters.

Moreover, you can reduce risk considerably by spreading your money out across most, if not all, of the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; and Utilities). This way, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or changes in investor opinion.

You also increase your chances of finding a stock that could surge and rise above the market average.

If you are reluctant to hold a 100%-stocks portfolio you might wish to consider keeping a portion of your investment funds in relatively short-term fixed-return investments, with maturity dates of a few months to no more than two to three years in the future.

These fixed-return investments will lose value when interest rates rise, but not enough to make a serious dent in their value. You can hold them till maturity, then get your money back and reinvest.

COMMENTS PLEASE&#8212Share your investment experience and opinions with fellow TSINetwork.ca members

Have you ever been invested in an asset allocation fund? Were the results satisfactory? If you got out of the fund, what was the reason? Let us know what you think.