Many people in the investment industry promote asset allocation funds as a simple and profitable way to assemble a diversified portfolio of stocks, bonds and cash equivalents.

But as is so often the case, the product rarely lives up to the hype.

How asset allocation funds actually work

Asset allocation funds are mutual funds that 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” — a computer program that makes trading decisions based on a preselected set of rules for interpreting financial statistics.

Computer modelling makes this investment approach sound 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.

Low interest rates make now an unpromising time to hold bonds

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

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With interest rates continuing to remain at 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; in place of capital gains, their bond holdings could produce capital losses.

Our long-term strategy can generate more lower-risk profits

Instead of 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.

A better way to hold fixed income investments

If you are reluctant to hold a 100%-stocks portfolio then one alternative to consider is to keep 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.

Our newsletter for conservative investing, Canadian Wealth Advisor, shows you how to protect your money and keep it safe—without sacrificing the potential for strong returns.

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