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 v. long-term, investment-grade v. high-yield (or junk) bonds, convertible, etc.

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

  • Market capitalization - Market cap simply refers to the value of all of a company's outstanding common shares times the current market price. Stocks are classified based on size as follows:
    • Large-cap stocks $5 billion or more
    • Mid-cap stocks $1 billion - $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-cap 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.
    • Value stocks tend to trade at a lower price relative to their fundamentals (i.e. dividends, earnings, sales, etc.) and are thus considered undervalued by a value investor. Common characteristics of such stocks include a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio. Value stocks tend to outperform growth stocks during a falling market.

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.

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.

Portfolio Styles: Active vs. Passive

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