Yesterday we learned about asset allocation, where you decide which asset classes are right for you. Today, I’ll help you decide what investments are right for you inside a specific asset class. Again the name of the game is managing risk, this time by diversifying within an asset class.
It wouldn’t do you much good to decide you want 75% of your $1 million in stocks and you just buy a bunch of GM or Wachovia stock. By picking the right mix of different asset classes you are successfully not keeping all your eggs in one basket, but you are still not diversified. Call me “The Diversifier!”
There other classes that talk about the different types of stocks, but before I explain how to diversify within an asset, let us have a gander at the different options within an asset class:
Stocks:
Large-Cap – These are the big stocks you’ve heard of. Google, IBM, Wells Fargo, Boeing, JP Morgan, & GE are all large cap stocks (ignoring current market conditions). Cap is for capitalization, which refers to the market capitalization of a company. Market cap is the product of the value of one share of stock and the number of shares that exist. Large-cap stocks have a market cap above $5 billion. As an example, GE’s market cap is about $170 billion. Generally speaking, these are the low risk investments of the stock world; established and stable companies that pay regular dividends from profits (Note: Google does not pay dividends, and is the exception of that fact).
Mid-Cap – With a market cap of $1 – $5 billion, these companies are much smaller than the large-caps. The companies you’ve heard of likely have a strong regional significance in your area or you’ve heard of them in passing. Aeropostale, Priceline, Netflix, Panera Bread, Tiffany & Co, & Lubrizol are all mid-caps. I doubt you’ve heard of Lubrizol, I sure never had. Most mid-caps you’ve never heard of. Because they are smaller and less established, there is more risk. Radical profits are more common among this area because they are more susceptible to market swings. Many pay dividends, but by no means most of them.
Small-Cap – Take a guess: less than $1 billion in market cap. There isn’t much of a point of giving examples, because even the most well known don’t have a national presence. The Cheesecake Factory is one that is near and dear to my heart. I love me some cheesecake. But with less than 150 stores in 34 states, they are national only in spirit, not in practice. The Cheesecake Factory is only small-cap because of the current market to boot, even 6 months ago they would have been considered mid-cap. Small-caps are a dime a dozen. There are gems among the rough, but it requires a lot of work to build a portfolio of quality of small-cap stocks.
International – The large, mid, and small-caps I used are just for domestic stocks. There are many more types in international. Including the caps, there are also Emerging Markets (developing countries), Southeast Asia, Europe, Russia, and many more. There isn’t enough time to discuss them all.
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Also worth discussing another day are the different investment options in all the asset classes we discussed yesterday. Bonds have short term, long term, tax free, government, corporate, etc. However the point and purpose of diversification is best explained using stocks, as most people put most of their money in stocks. So let’s look at how we might use the different categories to diversify our assets.
Since we’re going to invest most of our money (75% in stocks, we have to find the right mix among the options. We could pick individual stocks but there are only about 1,000 people on the planet that really should be doing that. The rest of us are better off in index funds. I’ve explained these in the past: index funds seek to mimic a specific market index and just follow the trend. The most common type of index is the S&P 500 index. Essentially buying an index fund in the S&P 500 buys you shares in all the companies listed in my large-cap and hundreds of others (most of my personal retirement is in S&P 500 index funds). You’re better off putting most of your 75% in some kind of index. We’ll we want to put $500,000 in an index fund which leaves $250,000 to be invested in the other categories.
The other categories carry more risk, but the potential return is greater. There are indexes that follow these categories too. We could put $50,000 in mid, and $50,000 in small, which leaves the final $150,000 for international. International is often considered the riskiest, but when you consider established companies like Deustche Bank, BP, Nestle, and Vodafone are all international, they are safer than most mid and small-caps. The risky ones are emerging markets, mostly because of political instability. China Mobile & Samsung are both in emerging markets, but most investments will be in companies you’ve never heard of and can’t pronounce. They offer the greatest potential rewards (about 30% of my personal investments are international).
Always keep in mind that the point of diversification is not to own as much as you can, it’s to give your portfolio stability. Often times when the US is doing well, Europe or Asia is not, and vice versa. The US has traditionally been the best place for everyone to keep their money. This is why even many citizens of other countries put their money in US institutions. The tired reference of China owning the US government is because they trust the stability the US offers. China’s economy is much less stable, and since they rely on our economy for their survival, it makes perfect sense for them to put their money in the US.
This course is meant to explain what diversification is, but I did not illustrate the advantages. For that you’ll need to see the supplement, tomorrow.
 By The Weakonomist |
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