Investing in the stock market is about buying stocks, but you need a strategy that combines stocks with other asset classes, in particular bonds and cash.
That combination is called asset allocation and its purpose is to provide you with the best opportunity to avoid major losses and take advantage of possible profits within your time horizon and considering you tolerance for risk.
This series of articles is looking at asset classes, specifically stocks, bonds and cash. In this article, we'll focus on stocks.
Stock Asset Classes
Stocks are not interchangeable. Some perform better in a particular set of economic circumstances, while others won't perform well in the same circumstances. How you add stocks to your portfolio - individual stocks, stocks mutual funds, or stock exchange-traded funds - is a personal choice and depends on your tolerance for risk.
There are a number of ways to define stock asset classes. You are probably familiar with these terms. Here is a basic list of stock asset classes to get started:
- Large-cap
- Mid-cap
- Small-cap
- Growth
- Value
- Blend
- Industry segment
- Foreign
If look at these possibilities, it is obvious that they can be combined in a number of ways. One of the methods you to consider is organizing stocks using this basic formula: (size) + (style) + (industry segment) = stock component. The basic idea is to pick stocks that cover different parts of the formula.
For example, you might have a large-cap value transportation stock in the same portfolio with a mid-cap growth technology stock. If you choose mutual funds or exchange-traded funds, you need to be careful that there is not much overlap in the fund components. For example, you don't want two funds that are large-cap growth stocks concentrated in health care.
The size part of the equation is obvious. You don't want all of your stocks in the same size range. A portfolio more heavily weighted towards large-cap stocks would be considered more conservative than one that favored small-cap stocks.
Yet, almost any portfolio needs a good spread of size ranges with more emphasis given to the size that matches your tolerance for risk.
Style (growth, value, blend) is a designation some investors may recognize as the same as that used for mutual funds. The differences are that the market identifies stocks by their performance and stock price, whereas mutual funds self-identify, although organizations like MorningStar.com challenge fund styles by looking at what they actually invest in.
Blend may seem like an unusual style for an individual stock, however it makes sense when you think of it as a combination of growth and value, which are not mutually exclusive.
Industry segment is one of the most important parts of the equation. Some segments will do well in certain market conditions, while other segments will not. Take care to not overload your portfolio with one or two segments.
Foreign Stocks
There is a good case to be made that your stock asset class should include some exposure in foreign markets, which can outperform domestic stocks in certain circumstances.
Probably not a bad idea, but I would put foreign stocks last on my to-do list. This is a complicated market to study and pick stocks from. You may be better off with a mutual fund or exchange traded fund that employs professional managers. In no case should foreign stocks be more than 10 percent of your portfolio.
There are mutual funds that build an asset allocation model with the claim that you really don't need other funds to be protected. Approach these funds with caution, since investment guidelines for the fund manager may allow discretion in the fund structure, which is a complicated way of saying, the fund manager may chase returns at the expense of the asset allocation model.
Some mutual funds are marketed by age. For example, the fund may be designed for 40-year-olds and is designed to adjust the holdings as time passes, so by the time you are 60, the fund is aligned with the needs of that age group. Sounds good, but you will need to follow the fund closely to make sure it still matches your needs.
Next, I'll look at the bond asset class.
