Everyone knows the ancient advice not to "put
all your eggs in one basket". A diversified
portfolio is indeed a time-honored means of reducing
investment risk by spreading out the "eggs"
among many baskets.
We design client portfolios intended to provide
the broadest reasonable diversification across numerous
asset classes. We believe this not only reduces
risk but also generally increases long-term returns
and maximizes our clients' odds of meeting their
financial goals.
In a broadly diversified portfolio, the various
components are not perfectly correlated with one
another. This means that not all asset classes move
in the same direction at the same time. One asset
class may go up at the same time another is going
down. The net result is a portfolio with less volatility
without sacrificing total returns.
Many investors believe that because they have a
dozen mutual funds or thirty stocks that they are
have a prudent degree of diversification. They are
likely mistaken. True diversification is not determined
by the number of funds or securities in a portfolio
but by how broadly the portfolio is allocated among
the various asset classes available.
Many portfolios are allocated exclusively to the
single asset class of large US growth company stocks.
Such portfolios omit: small stocks, value stocks,
international stocks, and fixed income securities,
and, in our view, are not prudently diversified.
If large US growth stocks fall out of favor for
a time (as occurred April 2000 - September 2002),
then those portfolios will suffer huge losses.
We can help new clients review the diversification
and risk of their current portfolios and recommend
changes.
Academics divide the world's investable assets into
these classifications:
_ Broad classifications: Stocks
vs. Bonds vs. Cash vs. Real Estate.
_ Fixed income is differentiated on the basis of
maturity (long-term vs. short-term) and credit quality
(investment grade vs. junk bonds, for example).
_ Stocks are differentiated as
(1) Large company vs. Small company
(2) Growth company vs. Value company, and
(3) US company vs. International company.
_These dimensions are then combined to define an
asset class. For example, small international value
stocks are considered one asset class.We use a broad
mix of these asset classes when designing client
portfolios.
No. Historical research into stock returns indicates
that certain asset classes have indeed returned
substantially more than others. While this trend
may not continue, we believe that exposure to these
better performing asset classes gives our clients
the opportunity to enjoy higher expected returns.
Researchers have identified a relatively large return
"premium" for investors in value stocks
and a smaller premium for investors in small company
stocks. We, therefore, normally design portfolios
that are "tilted" toward a larger allocation
to small and value stocks.
Value stocks can be contrasted with growth stocks.
Value stocks typically have low price-to-earnings
ratios, high debt levels, and modest growth expectations.
They are not normally exciting or glamorous companies
and frequently have experienced recent business
problems. Value stocks are often in industries like
chemicals, heavy manufacturing, and energy.
Growth companies, on the other hand, are just the
opposite. They are highly priced, highly profitable,
fast growing, and highly regarded by the public.
The classic examples of growth stocks are found
in the technology industry.
Academics believe that value stocks have higher
returns as a reward to investors for bearing the
additional risk of investing in distressed or highly
leveraged companies.
