I often discuss the benefits and advantages of having a diversified portfolio. What exactly does that mean? A critical point to understand is the importance of having various asset classes in your portfolio. An asset class is simply a group of stocks or bonds that share similar characteristics. These businesses are not necessarily in the same industry. Asset classes generally focus on the size and value of the companies within the group.
When you start researching the various index and mutual funds, you’ll see terms such as small-cap, mid-cap, and large-cap. Those terms simply categorize the average size of a company in a portfolio. A large-cap company is one that is worth a lot of money in the stock market. These would be the giants of American business – Walmart, Google, and IBM for example.
What Exactly is Market Cap?
The term “cap” stands for capitalization, which is the theoretical value of a company. It is the total of the amount of shares outstanding times the current market price. If you had a company that had one billion shares of stock outstanding, and each share was worth $100, the capitalization of that company would be $100 billion. If those shares were only worth a dollar, the capitalization would be only $1 billion. That essentially describes the difference between a large-cap and a small-cap company. As you can imagine, a mid-cap company would fall in between those ranges.
The size of a company plays a very important role in market returns. Companies move at different speeds depending on their size – you can use the image of a boat as an example. While large companies operate like much like a crude oil carrier, small companies may navigate like a yacht, being able to maneuver and adjust to business conditions easier than an established powerhouse.
There is greater risk with those smaller companies too, since some will be like “ships in the night” and experience harder times during the storm of an economic downturn. However, that risk is often rewarded with higher returns since investors can enjoy the period of time when a company is going through rapid growth and success as it expands its operations.
Value and Growth Companies
In addition to being categorized by size, another concept to understand is the characteristics between value and growth. There are various ways that funds rate businesses, but the basic idea is the same for both classes.
A value stock is one that for whatever reason is not popular with investors. The company may be on sound financial footing, may have a very solid business model, and may turn a consistent profit. Despite those qualities, the company does not capture the excitement of Wall Street and is not priced where it probably should be. As an investor, that is usually a good sign, since it means we are probably getting a bargain and we are going to buy the stock at a “sale price”. A value fund is a collection of companies that meet that criteria.
On the other hand, growth stocks are popular with investors. Most of them are willing to pay a premium to get the stock. The company may be in a very hot sector or is establishing a track record of consistent growth and profitability. Growth stocks are usually the rising stars of Wall Street and it is nice to be in on the action while a company is expanding. However, just because a company is a growth stock today does not mean it will be tomorrow. Today’s rising stars may be tomorrow’s duds.
Other Benchmarks To Consider
Blend funds are popular, since they typically combine a mix of size, value, and growth. One of the most popular examples is that of the Standard and Poor’s 500. Standard and Poor’s Financial Services is a company that publishes financial research and analysis on stocks, bonds, and other commodities.
The “S&P 500” or the “S&P” is an index that is based on the market cap of 500 of the largest companies in the USA. This is the most common benchmark of the US Stock Market. S&P has many other indexes that it tracks based on size, value, and growth, and many financial institutions offer funds based on the companies represented within those groups.
In addition to the asset classes available in the USA, there are also many international funds that feature businesses from around the world meeting similar criteria.
While markets may move in sync based on worldwide economic conditions, the US and international stocks tend to go up and down at different rates, and are also sensitive to the currency value of a particular country based on its value against the US dollar. Because of this, international funds can provide another excellent layer of diversification.
Although you may be comfortable with being close to home, it is really worthwhile to consider adding international stocks into your portfolio. Over half of the investment capital in the world is headquartered outside the borders of the USA.
Technology is making the world a smaller place. You are likely familiar with many household names that are provided by foreign companies. While international stocks may not have performed as well as their American counterparts in recent years, history shows that they also experience times of excellent growth. If you are looking long-term, it is worth investigating.
The Lure of Emerging Markets
Another class of international stock that has gained a great deal of attention is that of international emerging markets. These markets are in countries where the potential for economic growth is particularly high. While these markets may be much more volatile than that of well-established countries, they have also provided excellent gains. If you do your homework on emerging markets, they tend to either perform spectacularly well or extremely bad. However, when the dust settles, they tend to give investors very strong long-term results.
Think of countries like China, Russia, Brazil, and India. These countries continue to expand and change their economic systems to produce more and more growth. Being exposed to these types of expanding markets can be beneficial to even the most conservative investors, despite the inevitable growing pains.
Use Asset Classes to Build a Sound Portfolio
Understanding asset classes is critical to sound investment planning. There is a great deal of academic data that indicates which asset classes have historically performed the best. When you base your strategy on sound research instead of being reactionary to market conditions, it can give you solid foundation for a lifetime of success.