The Portfolio Pyramid: How to Diversify Your Portfolio
Remember the food pyramid for building a balanced diet? The portfolio pyramid covers the essential elements of a healthy, balanced portfolio.
The portfolio pyramid is a way of looking at your portfolio to determine if it's truly diversified both across and within asset classes. As you can see below, the pyramid breaks down a portfolio into manageable layers, making it easy to uncover any unhealthy symptoms.
Asset allocation: the foundation of your portfolio
The foundation of the pyramid is asset allocation. Your asset allocation determines the broad risk level of your portfolio, which should match your risk profile. Then once you've diversified across asset classes, you can start diversifying within asset classes.
Market capitalization
The size of a company is often measured by its market capitalization - the company's stock price multiplied by the number of outstanding shares. On the pyramid, market cap denotes the percentage of large vs. small companies in the stock portion of your portfolio.
Small-cap stocks tend to be riskier than large-caps, but have the potential for more upside. A sound diversification plan includes both, because nobody knows which of these two asset classes will be in favor at any particular time. For example, in 1998, domestic large-caps outperformed small-caps by 31 percentage points. But in 2003, small-caps outperformed by 19 percentage points.
Style
Next up is style, or the balance between growth and value investing. A mix of both is recommended, and the difference in performance can be dramatic. For example, in 1999, small-cap growth outperformed small-cap value by 44 percentage points. But in 2000, that was reversed and small-cap value outperformed by 44 percentage points. And styles also respond to markets differently.
Sector
Every stock is in an industry, and every industry is in a market sector. Holding too many investments in the same sector can be risky.
Industry
Jumping up to the next layer in the pyramid, the 10 sectors comprise 59 industries and 123 sub-industries. Even when a sector's performance is up, not all industries within that sector will perform identically.
In 2005, the consumer discretionary sector was down 7%. Yet if we look closer at this sector we find it contained 27 different sub-industries which had a mixed performance. Two notable examples are the 49% loss in automobile manufacturers and the 26% gain in homebuilding. Depending on what industry you held within the sector, your return could have been quite different.
The lesson? For a balanced diet, after you diversify across sectors, diversify across the industries within a given sector.
Geography
Over the past 36 years, the U.S. has a 0-36 record as the best performing market in a single year. This shows that you should look at investment opportunities outside the U.S..As with sectors and industries, your portfolio should include a mix of different countries.
Manager
Next comes managing your managers. It can be risky to have all your actively managed mutual funds with the same portfolio manager. Suppose the portfolio manager leaves the firm? Or the fund company goes through a disruptive restructuring? How might changes like these affect your portfolio? Hence, it makes sense to diversify across managers, as well.
Stock
Finally, at the top of the pyramid we have the individual stock level. This is where your greatest risk likely resides. As you create your portfolio, be watchful of inadvertently concentrating your position in a single firm.
Remember the tragic headlines of Enron employees who suffered great losses in their retirement plans? That's because they were over-concentrated in Enron stock. Enron is not an isolated incident. Many supposed "blue chip" companies have imploded in their day -- Conseco, Kmart, WorldCom, and United Airlines to name a few.
To reduce the risk of that type of portfolio meltdown, diversify your stock holdings so that no more than 5% of your portfolio is represented by any one stock. And if you have less than $50,000 to invest, then you may want to consider mutual funds, until such time as your pool of investment capital has grown sufficiently to warrant investing in individual stocks.
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The portfolio pyramid is a way of looking at your portfolio to determine if it's truly diversified both across and within asset classes. As you can see below, the pyramid breaks down a portfolio into manageable layers, making it easy to uncover any unhealthy symptoms.
Asset allocation: the foundation of your portfolio
The foundation of the pyramid is asset allocation. Your asset allocation determines the broad risk level of your portfolio, which should match your risk profile. Then once you've diversified across asset classes, you can start diversifying within asset classes.
Market capitalization
The size of a company is often measured by its market capitalization - the company's stock price multiplied by the number of outstanding shares. On the pyramid, market cap denotes the percentage of large vs. small companies in the stock portion of your portfolio.
Small-cap stocks tend to be riskier than large-caps, but have the potential for more upside. A sound diversification plan includes both, because nobody knows which of these two asset classes will be in favor at any particular time. For example, in 1998, domestic large-caps outperformed small-caps by 31 percentage points. But in 2003, small-caps outperformed by 19 percentage points.
Style
Next up is style, or the balance between growth and value investing. A mix of both is recommended, and the difference in performance can be dramatic. For example, in 1999, small-cap growth outperformed small-cap value by 44 percentage points. But in 2000, that was reversed and small-cap value outperformed by 44 percentage points. And styles also respond to markets differently.
Sector
Every stock is in an industry, and every industry is in a market sector. Holding too many investments in the same sector can be risky.
Industry
Jumping up to the next layer in the pyramid, the 10 sectors comprise 59 industries and 123 sub-industries. Even when a sector's performance is up, not all industries within that sector will perform identically.
In 2005, the consumer discretionary sector was down 7%. Yet if we look closer at this sector we find it contained 27 different sub-industries which had a mixed performance. Two notable examples are the 49% loss in automobile manufacturers and the 26% gain in homebuilding. Depending on what industry you held within the sector, your return could have been quite different.
The lesson? For a balanced diet, after you diversify across sectors, diversify across the industries within a given sector.
Geography
Over the past 36 years, the U.S. has a 0-36 record as the best performing market in a single year. This shows that you should look at investment opportunities outside the U.S..As with sectors and industries, your portfolio should include a mix of different countries.
Manager
Next comes managing your managers. It can be risky to have all your actively managed mutual funds with the same portfolio manager. Suppose the portfolio manager leaves the firm? Or the fund company goes through a disruptive restructuring? How might changes like these affect your portfolio? Hence, it makes sense to diversify across managers, as well.
Stock
Finally, at the top of the pyramid we have the individual stock level. This is where your greatest risk likely resides. As you create your portfolio, be watchful of inadvertently concentrating your position in a single firm.
Remember the tragic headlines of Enron employees who suffered great losses in their retirement plans? That's because they were over-concentrated in Enron stock. Enron is not an isolated incident. Many supposed "blue chip" companies have imploded in their day -- Conseco, Kmart, WorldCom, and United Airlines to name a few.
To reduce the risk of that type of portfolio meltdown, diversify your stock holdings so that no more than 5% of your portfolio is represented by any one stock. And if you have less than $50,000 to invest, then you may want to consider mutual funds, until such time as your pool of investment capital has grown sufficiently to warrant investing in individual stocks.
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posted by Bob Moser at
5:21 PM
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