Many investors see asset allocation funds as an easy and profitable way to diversify between stocks, bonds and cash equivalents.

What you get when you buy units of asset allocation funds

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 feel that the bond market is depressed and poised 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 a so-called “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, but 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 a bad time to hold bonds, either directly or through asset allocation funds

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 now at historic lows, 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.

Our long-term strategy puts you in a better position for lower-risk profits than asset allocation funds

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, including our flagship publication, The Successful Investor.

Moreover, you can eliminate market-timing risk 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 stumbling upon a market superstar — a stock that does two to three (or more) times better than the market average.

If you want to hold fixed income investments…

If you are reluctant to hold a 100%-stocks portfolio—and many people are—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.

You can get our latest risk-cutting strategies and clear, plain-English analysis of dozens of Canadian stocks in The Successful Investor. What’s more, you can get one month free when you subscribe today. Click here to learn how.