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Diversifying Your Stock Investments

By Mark Biller
© Sound Mind Investing | December 2010
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We've often written that your most important investment decision is how much of your portfolio to allocate to stocks and how much to fixed-income investments (bonds). Diversifying by shifting money from stocks to bonds has historically had the effect of lowering overall returns, but also greatly reducing the volatility of the portfolio.

While this stock/bond allocation decision is the most important diversification issue, it is not the only one you must address. After deciding how much of your portfolio to allocate to stocks generally, it is important to then take the next step and diversify between different types of stocks.

To assist in this process, SMI divides the U.S. stock market into four parts, or risk categories. (A fifth category, not discussed in this article, includes funds that invest primarily in foreign companies.)

In categorizing domestic funds, we make two distinctions. The first distinction is when we separate funds that invest primarily in large companies from those that invest in smaller companies. Larger companies are slower growing, but usually safer during recessions. Smaller companies have much greater growth potential, but are accompanied by greater risk.

The second distinction we make is based on a fund's "style." This refers to what kind of stocks a particular fund normally buys.

Funds typically fall into one of two major groups. The "value" group emphasizes how much you are getting for your investment dollar, meaning the price paid for each stock is very important. The "growth" group focuses instead on the growth potential of a company. Table: Different Fund Categories Offer Different Risks and RewardsIf it has great future prospects, a growth fund may buy its stock regardless of whether it trades at an expensive price.

When we put these two criteria — size and style — together, we arrive at our four risk categories. Funds investing in large/value-priced companies are placed in SMI risk category 1, and those focused on large/growth-priced companies go into category 2. Likewise, funds investing in small/value-priced companies compose SMI risk category 3, and small/growth-priced funds make up category 4. (For more on the SMI risk categories, see Chapter 15 of the Sound Mind Investing Handbook.)

The four risk categories can be thought of as rungs on a ladder. As with real ladders, it's safer near the bottom, and risk increases with each ascending rung. Therefore, you can expect risk to be lowest with the large/value funds of category 1, with risk gradually increasing as you move up into the large/growth, small/value, and small/growth categories respectively.

Charts A-D at left (and also here) help illustrate this point. They show the annual returns of the funds in each of these four categories as tracked by Morningstar over the past 15 years. (2008 is included in the overall returns but is not plotted, as the sharp loss that year across all categories visually obscures the other differences between the five charts.)

Note that over this period, the average annual returns of three out of four categories were fairly similar. Yet despite having similar average returns, the charts illustrate the different path each group followed.

A comparison of categories 1 and 4 best highlights this difference as the "tortoise and hare" contrasts are quite vivid. The small/growth funds of category 4 (Chart D) bounce up and down dramatically, with noticeably higher highs and lower lows than the other categories.

Meanwhile, category 1 (Chart A) chugged along with less frequent (and less severe) losses, but also lower gains in the good years. Looking at all four categories together, you can see the tendency for volatility to increase as you move up the risk ladder (left to right in the graphs).

It's also worth noting that the four categories move out of synch with each other. Look at the 2001 columns marked with arrows. Small/value funds gained 16% that year, while the other categories lost 4%, 22%, and 9%. Yet also check out 2007 when small/value funds were down, while the other three categories were up.

If you look closely, you'll find years where each of the four categories dominated, and others where each type lagged.

This tendency for different types of funds to move in and out of favor creates both a risk and an opportunity for investors. The risk is that by putting all your eggs in a single basket, it is possible to continually miss the better-performing fund categories.

This normally happens with investors who see a particular type of fund doing well, and move a big portion of their money to that hot category just in time for the market to start favoring another type of fund. Statistics that measure the amount of money moving into each risk category show that the investing public makes this mistake repeatedly, resulting in performance considerably worse than the market averages.

However, for those who understand the importance of diversification — meaning those who have at least some of their money spread across all of the risk categories — this type of market variation provides an opportunity. Chart E shows how a portfolio invested evenly among the four risk categories performed over the same 15 years. Not only were the average returns better than three of the four individual categories, but the chart shows more modest highs and lows as well.

In other words, a diversified portfolio provided returns that were better than three of the four individual categories, while also creating a smoother ride. Rather than continually chasing the hot fund group, diversifying among the risk categories turned out to be a more effective, not to mention less stressful, approach.

Higher returns with less risk: that's the winning combination proper diversification offers. End

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