Once the target asset allocation percentages have been defined, the next step is to diversify. For example, within the bond or fixed-income class, investment options include corporate bonds, government bonds, municipal bonds and so on. Further choices within the corporate bond category alone include short-term vs. long-term, investment-grade vs. high-yield (or junk) bonds, convertible, etc.

The range of options for stocks or stock funds is even wider. The information below refers to both individual stocks and mutual funds:

  • Market capitalization - market cap simply refers to the total dollar value of a company's outstanding common shares, calculated by multiplying the total number of shares outstanding by the current market price of a share. Stocks are classified based on size as follows:

    • Large-cap stocks, $5 billion or more
    • Mid-cap stocks, $1 billion to $5 billion
    • Small-cap stocks, less than $1 billion
    • Micro-cap stocks, less than $50 million

Diversifying across stocks with different market capitalizations is recommended. Typically, a larger allocation is made to large-cap stocks and smaller percentages to small- or mid-cap stocks.

  • Growth vs. value - stocks also differ by style. Typically, stocks (and mutual funds) are categorized as either growth or value oriented. Both styles have advocates who believe one is likely to outperform the other for different reasons.
    • Growth stocks are those whose earnings have been higher than average in the past and are expected to continue at a higher-than-average rate in the future.
      • They typically pay low or no dividends and often trade at high P/E ratios.

      • They tend to do well when the overall market is rising and over the long term tend to outperform slower-growing or stagnant stocks.

      • They are riskier than average stocks because of their high P/E ratios and the fact they pay little or no dividends.

    • Value stocks generally have a strong balance sheet and higher dividends, and are undervalued in the market given their earnings and asset values.
      • Value stocks tend to outperform growth stocks during a falling market.

      • Characteristics include a high dividend, low price-to-book ratio and a low P/E ratio.

      • Value investors believe markets are not always efficient and that it is possible to find companies trading for less than their true value.

As in other contexts, diversification helps to reduce risk in a portfolio. Since different types of stocks have different characteristics, their rates of return will differ throughout the economic cycle. For example, if a portfolio is composed of 50% stocks, and a large-cap stock fund is the only investment, it may perform better during a downturn in the market than a small-cap fund; but the small-cap may outperform the large-cap during a market rally.

Although diversification is an important method of optimizing a portfolio's performance, it is possible to become over-diversified. For more, see the article The Dangers of Over-Diversification.


Exam Tips and Tricks
Consider these sample exam questions about asset allocation
:

  1. Strategic asset allocation refers to the selection of:
    1. Specific securities to purchase
    2. Variation allowed within an asset allocation range
    3. Asset classes to invest in
    4. Target asset allocation for each selected asset class

The correct answer is "d", since "b" refers to tactical asset allocation.

  1. A value manager would consider all of the following in choosing a stock EXCEPT:
    1. Price/book value ratio
    2. Stock price growth rate
    3. Market share
    4. Price/earnings ratio

The correct answer is "b" - value stocks are evaluated based on the company's financials, including balance sheet ratios and market share. The growth rate of the stock is a factor that growth investors would use to evaluate a stock.



Active vs. Passive Portfolio Styles

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