The building blocks of diversified investing

Understanding what you should own will make you a better investor.

To increase your bottom line, spread your money around. Diversify.

While that advice sounds simple, few people truly understand how to construct a solid investment portfolio. They hear buzz about "real estate investment trusts," "high-yield bonds," and "small-cap value stocks," and load up on those investments without really knowing what they are, why they need them, and how they complement—or detract from—one another.

Even if you have a financial adviser, he may not have adequately explained the basic investment asset classes and their proper role in a diversified portfolio. Let's examine each of the major stock and bond asset classes and what you need to think about in order to build a well-diversified portfolio. In most cases, you'll want to invest through mutual funds, which spread your risk and, with the exception of index funds, offer the benefit of a professional money manager or management team.

Stocks

A diversified stock portfolio contains companies of different sizes and types. That's because broad categories of stocks rarely all move in the same direction at the same time.

The two most basic asset classes are "growth" stocks and "value" stocks. Growth stocks are those from companies that have reported above-average earnings gains for a few years and are expected to continue to report strong profits. The downside of growth stocks is that they're often riskier and more expensive than the typical stock, and pay little or nothing in dividends; profits are reinvested in the business.

Value stocks, on the other hand, are considered inexpensive relative to the issuing companies' actual worth and to similar stocks or the overall market. The companies have fallen out of favor with investors, perhaps due to several missed earnings projections, changes in top management, or a rise in the cost of labor or raw materials. Even a "blue-chip" company's stock can be a value stock, if the company's financial details suggest it's worth more than what's reflected in the stock's price.

"Growth and value stocks are like women's shoes," says David W. Polstra, a financial adviser with Polstra & Dardaman in Norcross, GA. "They go in and out of style at different times, and no one can predict when."

In the growth and value style categories, you should own some stocks in each of the following classifications:

Large-cap. These are the big-company, often "buy and hold" stocks whose names are familiar to even folks who don't know squat about investing: Coca-Cola, General Electric, Johnson & Johnson, Microsoft, and Wal-Mart Stores, to name a few.

Why you should own them: Domestic large-cap stocks tend to do well in our market when the US economy is strong. And they do well internationally when a weak dollar makes US-made products more affordable overseas. "The overall global economy has surged," Polstra says. "As workers overseas earn more money, they're able to purchase more US goods, strengthening the earnings of large companies."

Adds financial planner Carmine D'Avino, of Pinnacle Associates in Red Bank, NJ: "Because large companies often generate business internationally, they don't depend solely on the domestic economy, as most smaller firms do."

Mid-cap. These companies have market capitalizations that are generally in the range of $1 billion to $8 billion. Many are regional companies—banks, homebuilders, and utility companies, for instance—whose names may be unfamiliar to casual investors.

Why you should own them: Many mid-cap companies have higher growth rates than large-cap companies. (Think "still hungry" vs "fat and happy.") Mid-caps aren't as established as large companies are, but they're not in as much danger of going bankrupt as small companies are. That makes them a safer avenue for boosting growth.

Small-cap. A small-cap company usually has less than $1 billion in assets. Some small firms may be relatively new and worth only a fraction of that amount.

Why you should own them: "Small-cap stocks tend to perform strongly in the early to intermediate stages of an economic cycle, when monetary policies and bank lending conditions are more favorable," D'Avino says. Not surprisingly, small-cap companies, which often need to raise capital, have done extremely well over the past five years. (Small-caps returned 16.4 percent on an average annualized basis, according to Ibbotson Associates, a Chicago-based research firm and authority on asset allocation. By comparison, large-company stocks lost 0.6 percent over the same span.) Also not surprisingly, as interest rates begin to rise, many analysts think the time for heavy small-cap investing has waned.

International. Like domestic companies, it's possible to invest in foreign companies of all different sizes and types. Every stock portfolio should include at least some foreign stocks, because of the diversification they add. Some of the biggest and most successful corporations in the world are based on foreign soil: Bayer, Nokia, Siemens, Sony, and Toyota, to name a few.

Why you should own them: "Small international stocks are generally not multinational companies, and they do little business outside of their home countries," says Mark E. Balasa, a principal with Balasa Dinverno & Foltz, a financial planning firm in Itasca, IL. "They have a low correlation to the US economy, which makes them good diversifiers."

Large-cap internationals are less effective diversifiers than they once were because of the increasingly global economy. "Large-cap international stocks tend to do well when our economy is booming and poorly when it's lagging," says Ronald W. Rogé, an investment adviser in Bohemia, NY. Nevertheless, many financial planners, including Rogé, still recommend that you own at least some large-cap international stocks.

Real Estate Investment Trusts (REITs). These publicly traded companies own, manage, or both own and manage office parks, shopping malls, apartment buildings, nursing homes, and other types of investment properties. Other REITs act as lenders and pass interest income on to shareholders. Because Federal law obligates them to distribute 90 percent of their taxable income to investors each year, the dividend yields on REITs tend be very attractive compared with those of a typical stock—usually 5 percent or more.

Why you should own them: Returns for individual REITs, and for mutual funds that invest in REITs, tend to have little correlation to those of the broader stock market, which makes REITs a nice tool for diversifying your portfolio and a good hedge against inflation.

Bonds

Bonds come in three basic classes: governments (such as US Treasuries), corporates (issued by companies), and municipals (issued by cities). Interest earned on US government and corporate bonds is taxable on your federal return; interest from municipals generally isn't taxable.

Bonds aren't as sexy as stocks, but just about every investor should own some (we'll suggest how much a little later), for a measure of balance and stability. However, they're not entirely without risk. Most bonds are subject to both credit risk and interest-rate risk. If the bond issuer winds up in default, there's a chance you won't get repaid for what, in essence, is a loan to the issuer. And as interest rates rise, bonds decrease in value.

As with stocks, it's possible to mitigate some of these risks by building a well-diversified portfolio. Here are some of the major types of bonds you may want to include:

Long-term. In general, these are bonds that mature in 10 years or more. Long-term government bonds are considered the safest investments available.

Why you should own them: "Long-term bonds will provide the best total returns among bonds when interest rates are expected to decline," says David K. Sebastian, a financial planner with The Physicians Wealth Management Group in Parsippany, NJ. Moreover, long-term bonds allow investors to lock in an interest rate for many years, something that may have great appeal to, say, a retired person who wants steady, guaranteed income. The downside: If long-term bond rates are low, as they are today, locking in the rate is no advantage. Nor will the bonds be very popular, meaning they'll probably never trade at a premium to their face value.

Intermediate-term. Intermediate-term bonds mature in about three to 10 years. They react to interest rates the same way as long-term bonds, but their value doesn't fluctuate as much. And when they do fall, they recover rapidly, says Thomas A. Muldowney, managing director of Savant Capital Management in Rockford, IL. "They're the 'Weebles' of the bond world," he says. "They wobble, but they don't fall down."

Why you should own them: Since they mature sooner than long-term bonds, if rates rise after you buy them you don't have to wait as long to reinvest in bonds that pay better interest. In addition, Muldowney says, "if stocks increase in price, you could hold the risk in your portfolio in check by selling some stocks and reinvesting the proceeds in intermediate bonds. Alternatively, if bond prices rise, you can easily sell them and redeploy the money into stocks."

Short-term (including money-market funds). Most short-term bonds have maturities of less than three years. They offer the greatest stability and the least amount of interest-rate risk. Money-market funds invest in all sorts of highly liquid and safe securities, including certificates of deposit, and pay interest to shareholders. Many include check-writing privileges.

Why you should own them: "When the economy is poor and stocks are out of favor, investors flock toward short-term bonds, which they deem to be very safe," says Susan C. Kaplan, of Kaplan Financial Services in Newton, MA. That boosts their returns. Moreover, the short maturities allow you to avoid tying up your money for too long, important in times when inflation is high.

Money markets, which are more liquid than other short-term bonds, have their place, too, even though they don't earn as much as short-term bonds. They allow you to safely park money until you decide how to invest it—in the case of an inheritance, for instance.

High-yield (junk). The riskiest types of bonds to own, high-yields are rated below investment grade. They're issued either by established companies going through a rocky period, or by newer ones that don't have a long track record of sales and earnings. Both types of companies have to offer more to compensate investors for the added risk of default.

Why you should own them: While junk bonds aren't recommended for conservative investors, most people will benefit from a little junk. Junk bonds are actually safer than their reputation would have you believe (defaults are by far the exception, not the rule). And since many major mutual fund companies offer at least one high-yield fund, you can spread your risk over dozens of junk bonds, which lessens the impact on your returns if a couple of bond issuers default.

International. Like domestic bonds, foreign bonds vary in risk depending on the issuer. Those issued by industrialized nations are much safer than those from countries whose markets are still emerging. The same is true of bonds from established multinational companies vs those issued by smaller companies that limit their business to a single country.

Why you should own them: "Foreign bonds have all of the benefits and risks of domestic bonds, but their returns are subject to different currency movements and interest rates," says Dave Sebastian. "That can help to further diversify your bond portfolio." Like most financial planners, he suggests that you leave the selection of foreign bonds to a professional; the easiest way to do that is to purchase shares in a foreign bond mutual fund.

How much in each asset class?

The proportion of your portfolio to allocate to each asset class—and whether you really even need all of them is a decision that depends largely on your risk tolerance and how long you plan to invest.

For instance, if you're under 40 and expect to work at least 20 more years, you have plenty of time to recover from dips in the market, so you can afford to place as much as 90 percent of your money in stocks, many investment advisers say. The rest can go into bonds.

For middle-aged physicians, however, a 65 to 80 percent stock allocation makes sense. And for retired doctors or those approaching retirement age, investing 50 to 65 percent in stocks is sufficient.

Aggressive-growth investors should consider placing as much as 20 percent of their total investable assets in international stocks and another 5 percent in international bonds. Conservative investors might wish to avoid foreign issues entirely, although most advisers would suggest having at least a small portion of assets in them.

Because of their rather narrow focus, REITs shouldn't make up more than 5 percent of your total assets if you own a home or other real estate. If you don't, you can go to perhaps 10 percent.

These are only guidelines, however. You tailor them to fit your own situation, either on your own or with the help of a financial professional, before establishing your asset allocation. And once you've constructed your portfolio, review it at least once a year, to be certain it's still appropriate for your financial goals. (See "Is it time to rebalance your portfolio?" May 7, 2004.) To help make it easier to analyze your holdings, you may want to use one of the Internet-based tools discussed below.

Internet tools to analyze your holdings

Are your investments top-heavy with international stocks? A little light on domestic mid-caps? Do you have enough money in blue chips? Are any of your mutual funds drifting into other investment asset classes instead of sticking to the one you need?

If you're not sure, some free electronic tools are available to help you decide. The first, Morningstar's Instant X-Ray, lets you track your investments and shows your portfolio's asset class breakdown. You can even sign up for e-mail alerts that will let you know if your portfolio has experienced any sudden shifts in value. To sign up for Instant X-Ray, go to www.morningstar.com, click on "Tools," and then scroll down to "Instant X-Ray." The service doesn't cost anything, but you'll have to register as a member before the program will let you save your inputs.

Another program that you may find useful is SmartMoney's One Asset Allocation System (www.smartmoney.com/oneasset). Based on your answers to some general questions about your current asset allocation and overall finances, the program gives you a target allocation for five broad asset classes: large-caps, small-caps, international stocks, bonds, and cash. It's useful as a jumping-off point, to see whether it might be time to tweak your investment mix or discuss it with an adviser.

 

Dennis Murray. The building blocks of diversified investing. Medical Economics Sep. 17, 2004;81:32.