Mutual Fund Research Newsletter 1st Qtr. 2007. Copyright 2006-2007 Tom Madell, PhD Dec 30, 2006 Great Rewards for Long-Term Investors 2006 turned out to be an excellent year for many mutual fund investors and I hope this includes you. In 2006, one's asset allocations to stocks vs bonds vs cash, as well as which categories of stocks and bonds you were in, were particularly important in determining how well you did. And these are the very aspects of fund investing this newsletter focuses on as opposed to esoteric economic analyses! A reasonably high allocation to stocks was important this year because the average U.S. stock fund returned more than 3 times as much as the average bond fund - approx. 15% vs. about 4.25% for bonds. We have not been expecting more than middling performance at best from bonds for several years now, and so, if you followed our comments in this regard, you had more reason to invest away from bonds. In fact, we have even favored money market funds over most segments of the bond market during this period, an assessment that has turned out to have been correct. (Good money market funds returned close to 5% for the year.) So, 2006 was one of those years that the more you had in stock funds, the better you did. And, generally, if you are able to view your stock fund investments the same way most people view home ownership, as a long-term commitment without any cashing out or exchanges, your investments likely will do very well. Although there will be up and down years, after 10 or more years, your average yearly return in diversified stock funds should be somewhere around 10%, give or take a few percentage points, usually better than bonds, or elsewhere. But due to a variety of reasons, very few people actually hold their funds without some cash outs/exchanges for periods as long as a decade. This being the way things are, this newsletter gives you guidelines for making these changes to your portfolio, if you are so inclined, or changes become necessary for whatever reason. Not all years are going to be as good as 2006, obviously, and very few expected the magnitude of the gains. When there are significant gains, we can help you, if you so choose, to protect your gains. We can also try to help you uncover some areas where there appear to be a greater potential for profit than where most people are currently investing. But, if you can ride it out with some good investments over a decade or more without seeing the need to make any changes, you will probably do quite well even without this newsletter's help. In case, however, you are among the majority who do make changes, the strategies followed within my newsletters, so far at least, have proven to do even better than just "buying and holding." This year, though, has been one of the more difficult ones to have done better than the S&P 500 Index with only approximately 19% of U.S. diversified funds having done that, as of near year's end, according to the Wall Street Journal. It now appears that our recommended categories of stock funds from the beginning of 2006 may also fall slightly short of beating the Index. (We will publish complete portfolio performance data on our web site some time during January.) In order to have done better than "average" in 2006, it would have greatly helped to have had a significant allocation to international funds, been light on growth funds, and perhaps have some involvement in one or two other relatively non-diversified sectors such as real estate, energy, or emerging markets. These are all choices we have emphasized in recent years, especially overweighing overseas funds in 2006. You should remember, though, that my portfolios are designed to outperform for the longer term, not just for one quarter, or even just one year. If you look how our category recommendations made 2 years ago (and beyond) did by checking our site's archive section, you can calculate multi-year performance figures that will show that our recommendations generally were among the better performing categories over the ensuing years up to the present. However, right now it appears that many of our prior recommendations for the categories that once were undervalued, are now in just the opposite position. Just like at the beginning of 2006, it is hard to find truly undervalued categories to recommend. With that in mind, here are our current suggestions for those planning ahead for the next several years. 1st Quarter '07 Model Portfolio Recommended Overall Category Allocations These allocations remain unchanged from the 4th Qtr. of this year, except if you are a relatively aggressive investor. In this case, we are recommending a higher allocation to stocks and a lower allocation to bonds than at the start of Oct. For Moderate Risk Investors Stocks 52.5% Bonds 27.5% Cash 20% For More Aggressive Investors Stocks 65% Bonds 20% Cash 15% For Less Aggressive Investors Stocks 40% Bonds 35% Cash 25% Recommended Fund Categories Stock Funds (or ETFs) For domestic funds, we continue to favor the large blend category. Large value is close behind in appeal. We still do not particularly favor the growth category at this juncture, although our blend funds provide some exposure to growth. Unlike in previous years where certain specialized categories such as real estate or energy seemed undervalued, I can only continue to recommend a very small position invested in these categories if you do have each of the categories shown below included within your portfolio. Among foreign funds, we would also stick with the large blend category, although a case might be made other large cap funds. While there are many specialized international funds you might want to invest in, we continue to underweigh overvalued areas such as most emerging markets. We still do recommend a small allocation to funds focusing on the Asia/Pacific region. 2006 was not a great year for funds with an emphasis on Japan, but we expect that the comeback story there remains intact. Here are our specific recommendations: Category (Our recommended fund) Recommended percent of Stock Portfolio Large Blend (Vanguard Growth & Inc) 27.5 (or merely invest in Vanguard 500 Idx) Foreign (Vanguard Internat Gr) 27.5 Large Value (MainStay ICAP Equity) 17.5 Mid-Cap Blend (Vanguard Mid-Cap Idx) 12.5 Asia/Pacific (Vanguard Pacific) 7.5 Large Growth (Vanguard Morgan Growth VMRGX) 7.5 Bond Funds Have bonds turned the corner yet? We don't think so. We are still especially reluctant to recommend long-term bonds. After all, LT rates are already pretty low, with many ST bonds having nearly as high yields as LT ones. (And cash currently yields even more than LT treasuries!) Of course, if interest rates are cut significantly, LT bonds should outperform, but we don't think there will be enough of a slowing down in the economy to suggest these bonds will be particularly profitable for quite a while. But looked at from a longer term perspective of several years, long-term bonds usually show higher total returns when held by investors for a number of years than short-term bonds do. For now, we would continue to focus on bonds that can do well in a stable interest rate environment such as short-term bonds and GNMAs. However, LT munis, international, and some high yield bonds should still help you create a more diversified and possibly outperforming portfolio. Category (Our recommended fund) Recommended percent of Bond Portfolio Interm Govt (Vanguard GNMA) 20 Short Term (Vanguard S-T Inv Gr) 20 Long-Term (Vanguard L-T Inv Gr) 7.5 Corp Long-Term Muni (Vanguard L-T Tax Exempt) 25 High Yield (Vanguard Hi Yield ) 12.5 International (Amer. Cent. Intl Bond) 15 We thank you for your interest in this newsletter. We don't expect to convince the great majority of investors who find our site that they should subscribe to this newsletter or follow our suggestions. But for those who have generally followed our recommendations over a longer-term period, they were likely rewarded for having done so. Hope 2007 is a good year for subscribers in all respects! Tom Madell, PhD Publisher, Mutual Fund Research Newsletter http://funds-newsletter.com