Building The Perfect Portfolio
By Lisa Reilly Cullen

(MONEY Magazine) – Finding great funds is just the beginning. You also want to make sure your funds work well together, giving you exposure to various parts of the market while keeping a lid on risk. Luckily, you don't need a degree in finance to do that. Below we illustrate three model portfolios devised by Ross Levin of Accredited Investors in Edina, Minn. A basic portfolio can consist of as few as three holdings: funds that invest in large U.S. stocks, U.S. bonds and foreign stocks. (Such choices are readily available to most 401(k) investors.) Then, to refine your portfolio, you can add funds that target more specific market segments.

Adding new funds to an existing stable takes special care; they've got to fit in with what you already have. "The first question to ask about a new fund is, 'Is it redundant?'" says Diahann Lassus of Lassus Wherley & Associates, a financial planning firm in New Providence, N.J. "You may love this large-cap growth fund, for example, but if you've already got one, you could be duplicating your stockholdings." On the other hand, if you're one of the hordes who own a blue-chip index fund, adding a managed fund that uses a specific strategy to invest in certain types of big companies isn't a bad idea.

The best way to adjust or expand your portfolio is to buy new funds with fresh savings, says Levin. You can also take the distributed capital gains and dividends from a fund you own and shift them to a new one. Resist the temptation to make frequent changes, trading in a fund with middling returns in hopes of grabbing a rising star. Such churning is almost sure to hurt your returns. For one thing, in taxable accounts, selling could earn you a hefty capital-gains tax bill. And you may be bailing out of a fund just as its strategy is about to pay off. Lassus suggests replacing a fund only if "it has significantly underperformed its peers; if the parent company has merged and things are a mess; or if it's violated its investment philosophy somehow."