You’ve heard it here before: A well-diversified portfolio is a key component of a successful long-term investing strategy. But what exactly makes a portfolio, well, diversified?
Here are the different categories to consider when building your stock portfolio.
Domestic vs. Foreign
We all like to root for the home team, but it pays to invest in foreign players, too. Your international stocks could hail from developed countries, like Canada, the U.K. and France, or emerging markets, like Brazil, Russia, India and China. (You might know this quartet by its investing acronym BRICs.) The former group tends to be considered safer, given their relative economic security; the latter offers more growth potential.
“Market cap” refers to the value of a company, calculated by multiplying the share price by the number of outstanding shares. Generally, small-cap is defined as less than $2 billion, large-cap is more than $10 billion and mid-cap is anything in between.
Typically, small-cap companies come with greater risks, as they tend to be younger and have less access to capital (a.k.a. cash). Plus, investors may have a harder time doing their due diligence because analysts are less likely to cover them, says Certified Financial Planner Marguerita Cheng of Blue Ocean Global Wealth in Rockville, Md.
At the same time, “with risk comes the opportunity to grow and create possible return,” says Certified Financial Planner Vid Ponnapalli of Unique Financial Advisors in Holmdel, N.J.. “Small caps have more room for growth than large caps.”
Growth vs. Value
A growth company churns out big profits and has plenty of cash to continue expanding. That can be very attractive for investors, as prices can soar, especially during bull markets. Alternatively, a value company’s stock is relatively cheap compared to its earnings and sales (exhibited by a low price-to-earnings ratio). Its stock price may have been dragged down by a news event or because similar stocks are down, for example. The stock offers willing investors a potentially big return if the price can bounce back. Ideally, you want both types when building a balanced portfolio.
Every company gets labeled according to what its business does. For example, Facebook and IBM are in the tech sector. Other sectors include financials, consumer staples, health care and real estate. Because companies in the same sector tend to perform similarly, it’s smart to spread out your holdings over a variety of categories.
And make sure you have stocks in both “defensive” and “cyclical” sectors. The former remains relatively stable in any type of market, while the latter could profit greatly from a particular economic environment. For example, Cheng says investing in building materials, construction and industrial companies during expansion periods might be opportunistic. On the other hand, consumer staples and technology tend not to be affected as much by market cycles. “Smartphones are no longer a luxury; they are a necessity,” she says.
You’ll want a mix of bonds issued by corporations, states and municipalities (or “munis”) and the federal government (“Treasuries”), all of which have different risk levels and expected returns. Corporate bonds have the greatest potential returns—and the greatest risks. Since Treasuries are backed by the U.S. government, they’re considered relatively low risk. Munis fall in the middle.
You can also balance your bond portfolio by purchasing bonds with varying maturity dates. Short-term bonds mature in five years or less, intermediate bonds mature between five and 12 years and anything beyond is considered long-term.
It depends on several factors. Most importantly, you must consider your risk tolerance, risk capacity (how much you can afford to lose) and time horizon.
If your risk tolerance and capacity are high, and you’re, say, 26 and saving for retirement or a long-term goal, you may benefit most from an aggressive portfolio. That could be around 90 percent stocks, Ponnapalli says, including 30 to 35 percent international stocks, half of which might be in emerging markets. As you approach retirement, he recommends scaling back but still investing heavily in stocks over bonds—perhaps a 70/30 mix. He’d also dial down the international holdings and exposure to emerging markets.
Remember, too, that buying individual stocks and bonds is the riskiest route. If one investment tanks, you lose it all. Funds, however—particularly exchange-traded funds (ETFs) and index funds, which have relatively low fees—provide broad diversification, allowing you to invest in possibly hundreds of companies in one fell swoop.