; The Portfolio Pyramid How to Diversify Your Investments
Documents
Resources
Learning Center
Upload
Plans & pricing Sign in
Sign Out
Your Federal Quarterly Tax Payments are due April 15th Get Help Now >>

The Portfolio Pyramid How to Diversify Your Investments

VIEWS: 56 PAGES: 5

  • pg 1
									The Portfolio Pyramid: How to Diversify Your Investments

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.

The portfolio pyramid




Here, we'll primarily go through the side of the pyramid that has to do with stocks,
though the bond side is just as important.

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.

This is where Schwab's model asset allocation plans come in. They cover the
spectrum of risk by combining different asset classes: large-cap and small-cap
U.S. stocks, international stocks, bonds and cash.
Schwab's model asset allocation plans1




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-caps2 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. We
recommend a mix of both. Again, 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.

Styles respond to markets differently3




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. As the chart below shows, the
information technology sector saw greater single-year gains, but also saw heftier
single-year losses from 1990-2005.

Sectors tend to be riskier than the broad market4
Range of annual returns, 1990-2005
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.5 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 need to look at investment opportunities
outside the U.S. As with sectors and industries, your portfolio should include a
mix of different countries. For example, the Morgan Stanley All Country World
index includes 50 developed and emerging markets around the globe.

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 20% of your portfolio is represented by any one stock
(including stocks held in mutual funds). Generally, you need 40 to 50 stocks for
adequate diversification -- which means if you have less than $50,000 to invest,
you may want to consider mutual funds. Mutual funds can be a convenient, cost-
effective way to diversify your stock holdings.

You may still choose to own individual stocks. If you do, pick those stocks
carefully -- Schwab Equity Ratings® can help -- because not all stocks move like
the market.

In 2002, when the S&P 500® index was down more than 20%, 131 of the 500
companies had positive performance. And in 2004, when the market was up over
10%, nearly a quarter of the companies in the index had negative performance.

Not all stocks move like the market6




Is your portfolio truly diversified?
Remember, you need balanced servings from the many investment categories to
build a healthy portfolio. Using the portfolio pyramid, you can go through your
portfolio layer by layer and see what it takes to truly diversify across and within
asset classes

								
To top