One of the first practical lessons in investing is that a well-constructed portfolio means one that is appropriately diversified. The standard form of diversification is through combining asset classes - such as bonds and property funds - with equities. However, this is not necessarily enough to reduce or optimize portfolio volatility. Diversification by management style is often the missing link in getting the right mix.

What exactly is investment style?
In this investment context, a style can be defined as the method that managers use to buy stocks or other assets. Newcomers to the investment business are often surprised at the very considerable variation and latitude in style and its powerful impact on performance at a given time and over a period of time. (For related reading, see Focus Pocus May Not Lead To Magical Returns.)

According to Shawn Menard, writing in the Canadian Investment Review ("Risk Management: A Dynamic Process", 2000), this remains an underrated but extremely useful means of spreading risk. The deliberate use of variations in investment style as a means of reducing volatility is gaining considerable acceptance in the investment world; many believe that a symbiotic blending of management styles is an important part of the diversification process.

So-called "style rotation" has arguably become even more important in the new millennium, as the conventional equity-bond split has lost effectiveness through global capital market integration. Stylistic differences between money managers lead to a low correlation between or within asset classes that are managed with varied approaches. This is extremely valuable at a time when globalization tends to iron out differences between asset classes and many international markets are increasingly moving in tandem.

Offers and Guarantees of Style Diversification
Several investment advisory firms from around the world have developed plans to diversify their clients' portfolios across asset classes, within asset classes and across investment management styles. In the same way that different asset classes perform better and worse at different times, so too do varying approaches to management within these asset classes.

Some major university endowment funds specify diversification in terms of style and guarantee to hire a certain number of managers with varying styles. The University of Missouri, for instance, promises a minimum of five separate managers, providing "different and complementary strategies of equity investing". The objective is "to ensure the absence of either under- or over-exposure to particular style approaches." (For more insight, read How do university endowments work?)

The Main Styles
Value and Growth
The two classic stock-picking styles are those of value and growth. The value style entails buying stocks that are regarded as cheap, whereas growth stocks are expected to grow faster than the rest of the market. These two basic methods are quite different and, by having funds with both styles, investors are able to enjoy the best of both worlds. Particularly over the longer term, investors are likely to find that volatility can be reduced by mixing investment styles. (For more on these styles, read Warren Buffett: How He Does It and Venturing Into Early-Stage Growth Stocks.)

Momentum
Apart from these two classics of value and growth, there are several other fundamentally different approaches to the market. The momentum strategy is one. The idea behind this approach is that investments that have been doing well in the past and have gathered "momentum" are likely to continue doing well. Of course, it is necessary to figure out when the momentum will slow down or come to a halt. (To continue reading about this approach, see Riding The Momentum Investing Wave.)

Market Capitalization
Another form of style is the relative emphasis on market capitalization - small-, medium- or large-cap stocks. By shifting the allocation toward one size of company and away from another, very different results and performance can be obtained. In the extreme, small caps may be doing really well as a whole, while their big brothers take a loss. This is what diversification is all about. (To read more, see Market Capitalization Defined.)

Top-Down and Bottom-Up
Another important stylistic differentiation is between top-down and bottom-up approaches. The former entails looking at the "big picture", or the broader economic and financial scenarios, both locally and internationally, and only then moving "down" to consider specific sectors and, finally, the stocks of specific companies. Bottom-up is the opposite approach, where the focus is first and foremost on individual stocks. The basic assumption here is that good companies and their equities will thrive, even if market conditions are not particularly favorable. (For more insight, see Where Top Down Meets Bottom Up.)

Quantitative Approach
The quantitative approach is another possibility, and it relies heavily on computers for mathematical and statistical modeling. The idea is to remove all emotions from the process and have a computer check through enormous amounts of data to discover unrealized asset potential. This is, therefore, a purely technology-based means of stock picking or of asset selection. There is no shortage of such methods, but in the emotion-laden markets, which still depend heavily on people and their perceptions, computers have their limitations. (To read more, see Getting To Know Stock Screeners.)

Keeping an Eye on Styles
As is the case with other assets classes and sectors, rebalancing between investment styles also makes a lot of sense. It is important to monitor and evaluate whether your style mix is performing optimally and to change it where appropriate. In other words, style should be treated like any other asset that evolves over time.

It is not uncommon for managers to not always remain true to their styles. For this reason, it is also necessary to monitor how closely managers adhere to their stated styles.

Conclusion
There are many way of diversifying a portfolio. One of these is through combining funds that operate according to fundamentally different investment styles. Although most people think of diversification as combining asset classes, similar or better results can be achieved though a sensible mix of value and growth stocks, bottom-down and top-up approaches, and so on.

The object of diversification is to achieve a good rate of return at an acceptable level of risk. Precisely this can be achieved by accepting and operating on the fundamental reality that asset management in the broadest sense, and not just the choice of assets, is critical.

Furthermore, whatever approach is favored, it is important to note that different styles may work better at different times, within different market structures and with different managers. Portfolios can be optimized through exploiting these differences through actively monitoring and mixing styles according to the prevailing situation in the various investment markets open to you.

Related Articles
  1. Mutual Funds & ETFs

    The 4 Best T. Rowe Price Funds for Growth Investors in 2016 (TROW)

    Discover the four best mutual funds administered and managed by T. Rowe Price that specialize in investing in stocks of growth companies.
  2. Mutual Funds & ETFs

    The 3 Best T. Rowe Price Funds for Value Investors in 2016

    Read analyses of the top three T. Rowe Price value funds open to new investors, and learn about their investment objectives and historical performances.
  3. Investing

    3 Healthy Financial Habits for 2016

    ”Winning” investors don't just set it and forget it. They consistently take steps to adapt their investment plan in the face of changing markets.
  4. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  5. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  6. Mutual Funds & ETFs

    Top 5 Wellington Funds for Retirement Diversification in 2016

    Discover the top five Wellington Management funds for retirement diversification in 2016, with a summary and performance details of each fund.
  7. Mutual Funds & ETFs

    3 Morgan Stanley Funds Rated 5 Stars by Morningstar

    Discover the three best mutual funds administered and managed by Morgan Stanley that received five-star overall ratings from Morningstar.
  8. Investing Basics

    4 Things That Make a Stock a Safe Bet

    No investment is a sure bet, but you can reduce your chances of taking a loss by choosing fair-priced stocks with growth potential and low volatility.
  9. Retirement

    Smart Ways to Tap Your Retirement Portfolio

    A rundown of strategies, from what to liquidate first to how much to withdraw, along with their tax consquences.
  10. Chart Advisor

    How Are You Trading The Breakdown In Growth Stocks? (VOOG, IWF)

    Based on the charts of these two ETFs, bearish traders will start turning their attention to growth stocks.
RELATED FAQS
  1. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  2. What's the difference between a stop and a limit order?

    Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you ... Read Full Answer >>
  3. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  4. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  5. Can hedge fund returns be replicated?

    You can replicate hedge fund returns to a degree but not perfectly. Most replication strategies underperform hedge funds ... Read Full Answer >>
  6. Does mutual fund manager tenure matter?

    Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center