Diversifying a Portfolio with Asset Classes
Diversifying a Portfolio with asset classes
A good approach to diversifying with stock asset classes begins with viewing the U.S. equity portion of a portfolio. The total U.S. market profile is about 72% large cap, 19% mid cap, and 9% small cap (refer to the table on market organization in Ch. 3). Using this profile as a gauge gives you something to use as a comparison for your own individual portfolio holdings. Getting too far out of line with the market profile by adding a very large portion of one asset class may cancel the benefits of diversification and actually add additional volatility (SD). It will also introduce something called tracking error.
Tracking error occurs when a portfolio that is much different from the market profile is used. Such a portfolio will not follow the movements or returns of the total stock market.
A non-conforming portfolio will at times have higher returns than the market, but it will also have lower returns at times. Inexperienced investors are quite pleased if their portfolio is beating the market, but many simply cannot stand to see the reverse. Having a portfolio that is down when the market is up causes many investors to abandon their strategy and change things, which hurts returns.
The following portfolios are typical examples of those used by many investors, but they are not recommendations. What I'm trying to show is the process of developing a risk-controlled portfolio structured with recognized asset classes. It will be up to each individual investor to define their own risk profile and portfolio.
One of the simplest ways to build a portfolio is to use a mutual fund that tracks the entire market. A total market fund provides a lot of diversification because it has large cap value and growth stocks plus mid and small stocks in the exact proportion as the market. To further diversify, an investor should next add a total international fund. Usual recommendations for international exposure run from 20% to 40% of the equity allocation.
In the following examples all fund holdings add up to 100%. That is one recognized way of listing a portfolio. Viewing all accounts as part of the whole portfolio helps you get an overall view of everything you own. It also enables you to put assets in the most advantageous places.
Sometimes allocations are separated into percentages of stocks and percentages of bonds. Be sure you are clear on which way a portfolio's holdings are being presented or recommended.
In the following example, total international is 20% of the equity allocation. Equity is 60% of the portfolio and 12 is 20% of 60.
This simple equity allocation contains all the major stock asset classes except REITs.
William Bernstein writes in is book, The Intelligent Asset Allocator, "If over the past 10 or 20 years you had simply held a portfolio consisting of one quarter each of indexes of large US stocks, small US stocks, foreign stocks and high quality US bonds, you would have beaten over 90% of all professional money managers, and with considerable less risk."
If you wanted to add REITs, recommendations for allocations usually run from 5% to 15%. Although REITs are U.S. equities and mostly small and mid cap stocks, they are not considered in the market profile because they don't act like any other asset class, and the market does not contain a significant amount of REITs.
In many cases an investor may not have access to total market funds, especially in tax-deferred accounts through work or at various brokerage houses. When that occurs, a S&P 500 fund or a large blend actively managed fund would be a good choice. If an investor uses one of these choices, she might add a small cap fund. Then the portfolio might look like this:
Here is example that includes all the asset classes:
You could add a mid cap fund in the mix too, but mid caps aren't considered the best diversifiers because they act a lot like a combination of large and small. However, they can provide better-than-average returns at times.
The fixed income portion of your financial assets is the safe part of your portfolio. It has been described as a portfolio's belt and suspenders.
Bond funds are great diversifiers and the main controller of overall portfolio risk management.
Like stock investments, bond investments do not have to be complicated. One typical bond portfolio in a tax-deferred account might look like this:
It the example above, there is a total bond market component which covers many kinds of bonds and provides lots of diversification. The TIPs component will add an inflationary hedge. And finally, there is a higher-risk/higher return component in hi-yield bonds. You don’t want to add too much of a riskier component like hi-yield because the first purpose of bond holdings is to moderate risk, and there are times when hi-yield bonds can act much like stocks. For this reason, there are a few experts you do not recommend hi-yield bonds.
Bonds in a taxable account might look like this:
When using taxable accounts, it's best to go with tax-exempt or tax-deferred bond funds or taxes will eat up much of the return.
The cash portion of a portfolio might consist of money market funds, CDs, stable-value funds, and savings accounts. Putting all three primary asset classes together results in a full portfolio that looks like this:
Example of a diversified Total Portfolio: Stocks = 65%, Bonds=25%, Cash=10%. Note at all funds add to 100%
Large cap value fund - 16%
Large cap blend or growth fund - 16%
Small cap value fund - 6.5%
International fund - 20%
REIT fund - 6.5%
Bonds = 25%
Total bond fund - 15%
TIPS - 7.5%
Hi yield fund - 2.5%
Cash = 10%
Money Market - 5%
CDs - 5%
Other examples—You add the allocation appropriate for your situation.
Taylor Larimore’s Thrifty Three
Total Stock Market
Rick Ferri’s Core Four
Total Stock Market
FTSE All-World ex. U.S.
Here are a few final thoughts on asset classes. Historically, over long time periods, value stock and small stock asset classes have produced higher returns than the overall market.8 Some investors deliberately overweight these classes. If you consider something like this, remember that you will have higher tracking error and the results may not be see immediate results.
Note 8: Larry Swedroe, "Explaining the Value Premium," 2/2002, www.indexfunds.com