The amount of money that these goals require certainly seems unattainable for the average person to accumulate by putting their savings under their mattress. Chances are that if you stumbled across this article, this is not news to you. So you know the ‘why’ of investing, next comes the ‘what.’ A quick Google search about stocks will reveal that there is no shortage of people, businesses, articles, and TV personalities that are ready to tell you about their hot stock tip. But of course, you have heard about diversification too, likely accompanied by an idiom about a basket of eggs, so you know not to invest a significant amount of your money in one place. How many stocks do you need then?
To say that equity portfolio construction can be daunting for the amateur investor is a bit of an understatement. While stocks are not the only asset class that can make up a portfolio, most portfolios with the goal of growing over time will have some portion invested in the stock market. Historically stocks have been an excellent tool for investors with long time horizons to grow their wealth. An investing axiom to keep in mind: as you take more risk, the level of expected return rises. The principle of diversification can help mitigate stock and sector specific risk. At its core, diversification is the principle that combining multiple stocks that move less than perfectly with one another will create a portfolio that is less risky than each of them individually. The lower correlation two stocks have with one another, the greater the diversification benefit. To find a collection of stocks that share a low correlation with one another, we view diversification through several lenses.
Graph for illustrative purposes only. Weights are derived from Vanguard S&P 500 ETF which tracks S&P 500. Morningstar, 11/30/22
The first method of diversification when it comes to equity portfolio construction is to invest in companies across different economic sectors. The US market is divided into 11 Morningstar sectors, such as financials, energy, healthcare, and technology. Within each sector there will be stocks that do well and stocks that do poorly, but the prices of companies within a given sector typically move together closely over time. There is sound logic why this is the case; fundamentally, stocks reflect ownership of a company, and therefore the price of a company’s stock follow expectations of future cash flows. A new industry trend or development – for example in healthcare or technology will affect that sector’s stocks much more than it affects stocks in another sector. There are diversification benefits to be had by investing across all sectors. Our philosophy is to provide optimal diversification for your portfolio, which means market-like exposure across all sectors.
Another way we think about diversifying our exposures during equity portfolio construction is by investing in companies from all over the world. Many large corporations often derive revenue from many different countries. Apple for instance derives more than 60% of its sales (revenue) from outside of the US. Some argue that the geographical diversification gained from investing in large multinational firms based in the US provides all the diversification benefits of adding foreign stock into a portfolio. The US has led the stock market with its far higher proportion of tech companies in the world. Other regions and countries bring to the table expertise in other industries and areas. By investing in these, too, you stand to benefit from global sources of innovation and successes. It is apparent it is impossible to predict which countries or regions perform best over any timeframe. Owning them all reduces your portfolio’s risk as they perform differently in different periods.
Another way you can benefit by owning global companies is changes in currency value. If their currencies increase in value relative to the U.S dollar, that translates into more US dollars for US shareholders.
The last dimension we think of in our diversification strategy is company size, or market capitalization (market cap). Market cap is simply the combined value of a company’s shares. The stock market is broken down into large-cap, mid-cap, and small-cap companies. Unfortunately, there are no hard and fast rules about what the size cutoffs are for each category, but without splitting hairs over definitions it is important to note that about 80% of the whole stock market is made up of “large” companies. Furthermore, the typical indexes that usually serve as a proxy for the stock market’s performance such as the S&P 500, and the Dow Jones Industrial Average are made up of 100% large companies. Because small and large companies have different characteristics, an allocation to small-cap stocks can cause portfolio returns to significantly diverge from the returns of the traditional market benchmarks, for better and for worse. Throughout history, small companies on average have offered a higher return than their large cap, blue chip counterparts, but with more risk. The reason behind this is intuitive: small companies have more opportunities for growth, but don’t have the financial stability of large companies during challenging economic conditions, which creates a wider range of potential outcomes. Due to the less than perfect correlation with large-cap stocks, however, a small allocation to small-cap stocks serves to reduce the overall riskiness of a portfolio while also providing a higher potential for return. We maintain a small and broad reaching exposure to small-cap stocks to capture that diversification benefit.
By remaining invested across all sectors, countries of origin, and different size companies, we expect to reduce risk and improve risk-adjusted returns for you as our client.
Watch our video where we describe our investment management philosophy:
NOTE: This article offers general information and should not be acted upon without obtaining specific advice from a qualified professional. The information is not intended as investment, tax or legal advice, nor the solicitation for the purchase or sale of any security.