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

Related Articles
  1. Investing

    Valuing Small-Cap Stocks

    When done right, small-cap investing can improve the performance of your portfolio without adding a great degree of risk.
  2. Managing Wealth

    Why and How to Diversify Beyond Asset Class

    Diversification is a must for investment portfolios but it isn't enough. Investors have to have different exposures within asset classes.
  3. Investing

    The Top 5 All-Cap Growth Mutual Funds for 2016

    Discover five mutual funds that invest in a wide variety of stocks of different market capitalization with strong potential for growth in earnings.
  4. Investing

    5 Things To Know About Asset Allocation

    Overwhelmed by investment options? Learn how to create an asset allocation strategy that works for you.
  5. Financial Advisor

    Top 3 Aggressive Allocation Mutual Funds (FAMRX, TRSGX)

    Examine available information and analysis on three of the top-performing mutual funds in the aggressive allocation fund category.
  6. Investing

    The Top 5 Small-Cap Core ETFs for 2016 (VTWO, IJR)

    Learn how to get broad exposure to the U.S. small-cap equities market by investing in one of the top five exchange-traded funds for 2016.
  7. Investing

    The Top 5 Mid-Cap Value Mutual Funds for 2016

    Understand how mid-cap value stocks play a role in strategic asset allocation, and learn the best mid-cap value mutual funds to consider for 2016.
  8. Investing

    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. Investing

    What Is Strategic Asset Allocation?

    A strategic asset allocation takes a long-term approach to help an investor achieve their financial goals. Here's how it works.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center