Most investors do not have a balanced portfolio. They look for investments with little to no risk that still provide great rates of return. And by chasing this elusive chimera they miss the easy money they could make from having a good asset allocation in the first place and rebalancing it periodically.
It is like trying to coach football without knowing the purpose of the various positions on the team. So you send in three quarterbacks, two halfbacks, four wide receivers and a couple of field goal kickers. All too late you realize you have no one in your offensive line to block.
Many investors try to pick a few specific companies in the hope that these companies will do well. This risks picking too many famous quarterbacks. Any position over 15% of your portfolio significantly increases its volatility without increasing the average return. It is best not to put all your eggs in one basket. But again, that makes it critical to know what constitutes a basket. Here are four ways to make sure your portfolio is well diversified.
First, look at what percentage of your investments you put in each country. Putting all of your investments in the United States could be just as risky as putting them all in Greece. Countries are divided into developed countries, emerging markets and those even less developed, sometimes call frontier markets. Countries can also be divided by those with a high sovereign debt and deficit and those with better financial affairs. Countries have also been ranked in 10 categories of economic freedom.
Stocks can also be divided by company size. Larger companies are often less volatile, but smaller companies can provide higher returns. Company size is categorized by their capitalization, calculated by taking the current share price and multiplying it by the total number of shares outstanding. In other words, what would it cost to buy the entire company at the current share price?
Companies with a capitalization greater than $10 billion are considered large cap. Companies smaller than $2 billion are considered small cap. Between those two numbers is the midcap category. Companies over $100 billion are sometimes called mega-cap. And companies smaller than $300 million are often called micro-cap.
Third, stocks can be divided on a scale of value to growth. Value stocks have a high book-to-market value. They are priced reasonably in relation to the company’s assets. Value stocks often have a low price-to-earnings (P/E) ratio. These are all indicators that the company is a good buy when considering its intrinsic value or its current stream of earnings or dividends.
Growth stocks are not as reasonable. They have a low book-to-market value. Often they have little or no earnings and usually pay lower dividends if they pay them at all. Growth stocks are overpriced because the market is anticipating that the companies will have exceptional growth. They may not look like a good deal on account of recent earnings, but often earnings are growing at 40% or more every year. A few years of exponential growth often gets priced into growth stocks.
The higher prices for growth stocks are reasonable if they experience a few years of 40% earnings growth. But if one year only delivers 35% growth with a lowered expectation, the stock price can drop dramatically. Growth stocks have a higher P/E ratio because they expect earnings to continue to grow. Diversifying across the spectrum of value and growth stocks can help balance your portfolio’s volatility or boost your expected return.
Finally, stocks can be grouped by sector of the economy and industry. Morningstar divides the economy into three sectors and eleven subsectors. Sector rotation tracks nine different categories that tend to do better than average at different times of the business cycle. Value Line uses over 100 industry categories. The industry classification benchmark classifies every stock by industry, supersector, sector and subsector.
Your portfolios can be out of balance based on any of these groupings. Most of us are prone to invest in what we know. Experience with one type of investment makes you more likely to pick similar investments. You may have all U.S. large-cap stocks, the most common out-of-balance portfolio. These are the companies that everyone is familiar with.
A portfolio of Apple, IBM, Google, Microsoft, Oracle, Qualcomm, Amazon.com, Intel and Verizon is unbalanced in multiple ways. They are all U.S. stocks. They are all mega-cap. They are all growth stocks. And they are all in the information/technology industry.
These are all categories that are easily diversified. In fact, you can get the entire world stock market roughly in its current allocation simply by buying two exchange-traded funds (ETFs). The first is Vanguard Total Stock Market ETF (VTI). It contains over 3,000 stocks representing more than 99.5% of the capitalization of the U.S. equity markets.
An investment in VTI is about 71% in large cap, 20% in midcap, and 9% in small cap. It is roughly half value and half growth. And its largest sector is 19% in information technology. These mimic the ratios in the U.S. stock market. And the cost of owning this ETF is extremely low with an expense ratio of only 0.07%. If you wanted to invest according to the world’s stock allocation, you would put 44% of your money in this fund.
With your remaining money you would invest in the Vanguard Total International Stock ETF (VXUS). This fund has about 6,700 holdings from 44 different countries. It represents 98% of the world’s non-U.S. markets. Europe is about 43%, Japan 15%, Canada 9% and emerging markets 23%. It also has a low expense ratio of 0.20%.
With these two funds you would own the world’s stock market in exactly the proportions of global capitalization–all for the low average expense ratio of 0.14%. Any investment philosophy that deviates from this asset allocation should have a good reason to do so. Limiting your investment to 100 or so stocks in a typical mutual fund and paying a 1.2% expense ratio in the process is often a losing proposition. There are reasons to tilt your asset allocation, but the stock-picking expertise of a mutual fund manager is rarely one of them.
Not every categorization is worth diversifying. Only diversify your portfolio across the spectrum of the best investments. Investors make a mistake when they spread their money across whole life insurance, annuities, hedge funds, private placements and other investments with high fees, lockup periods, illiquidity and no public pricing. Many investment products are not on the efficient frontier of investment choices. Avoid them altogether.
We are offering an hour-long free seminar, “Your Portfolio Is Out of Balance,” as part of the NAPFA Consumer Education Foundation this Thursday, January 5, 2012, at 5:30 p.m. at the Charlottesville Senior Center. We will show you how to tell if your portfolio is well diversified and how to adjust it if it’s not. A question-and-answer session will follow.