Chapter 3 – How Diversification Works

Chapter 3

How Diversification Works

Diversification – A simple explanation: Spreading your money into many broad areas is called diversification. It works something like this: Let’s say you are packing for a trip to a place you’ve never been and you don’t know what the weather will be like. What do you do? You pack a variety—some light clothes, some heavier ones you can layer, and finally a coat. You want to be prepared for any kind of weather. You are reducing the risk that you won’t be prepared, no matter what. You do the same thing with your investments because you are investing in the future – a place you’ve never been and where you can never be sure what awaits you.

Diversifying in the market
Before you can substitute market diversifiers for clothes you need to understand some basics about how the stock and bond markets are organized.

Part I. Market Basics

The Stock Market
The stock market is exactly that – a market for shares of about 7200 publicly owned companies of all types and sizes. To organize the market, the companies are divided by size, represented by their worth, into large, medium, and small sized companies. Company size is also referred to as market capitalization (market cap). Market cap is all the shares of a company times the price of the shares. All of the buyable shares are owned by all investors, so the market actually works much like an auction with the sellers trying to get the highest price and buyers trying to get the best deal. From the view point of investor money, market organization can be thought of in terms of where that money is invested. For instance, if you invested $1.00 in a total stock market index fund (you can’t invest directly in an index), that dollar would be spread out to all companies in the fund, with a percentage to each company stock equal to it’s percentage of the index fund. If the largest stock is 2.5% of the fund (which would mean 2.5% of the stock market), then that stock would get 2.5 cents. A company one tenth that size would get 0.25 cents. The percentages (the market cap organization) is a natural representation of where investors actually put their money. A cap-weighted index simply tracks this.

There are other ways to make indexes, for instance there are equal weighted index funds where each company gets the exact same amount of the dollar. However, these funds are not mirroring where investors actually invest, so they are in disagreement with the consensus of all investors. That may not be bad, but it is different and represents a higher bet on smaller companies because they get more of the dollar. The top 10 companies currently represent about 15% of the entire market capitalization. In  other words, 15% of all investor’s money is in those top 10 stocks. The top 25 stocks represent almost a quarter of the whole market. There are thousands of small stocks that make up the bottom 20% of the market.

The stock market is generally divided up into three size categories; large capitalization (large cap), mid cap, and small cap. Different methods are used to categorize the size ranges. Morningstar currently defines large cap as companies with market caps above 8 billion. Companies with market caps between 8 billion and 1 billion are classified as mid size. Small size companies have market caps below about 1 billion. The size distributions are not constant because market cap changes with stock prices.

Indexes have been created to track the whole market as well as various segments of it. The Wilshire 5000 is one index that tracks the whole market, but the Standard and Poors 500 (S&P 500) is the best known index and it is used as a benchmark for overall market performance. The S&P500 is composed of 500 large companies selected by committee to reflect the overall performance of the market, but because of the market cap weighting, those 500 companies represent almost 80% of the whole market.

The S&P500 follows the total market’s movements very closely. The 500 stocks in the index contain all the market’s large cap stocks, those with market caps above 8 billion, and about half of the mid cap stocks. The remaining 6700 stocks in the total market are the rest of the mid caps and all the small caps. As you can see, there are many more small stocks than large, but in investor’s dollars or market movement, they don’t have much impact. They make up only 20% of the market’s overall capitalization. This weighting makes the market look like an inverted pyramid with large boulders on top, some pebbles in the middle, and grains of sand at the bottom.

In addition to the three size separations, the market is also divided into value stocks, growth stocks and those somewhere in between, which are called blend. There are various measures used to indicate whether a company is a value type company or a growth type company. So now we have nine “boxes” that segment the market: Large value stocks, large blend stocks, and large growth stocks. Then the same three separations for mid and small stocks. Incidentally, the S&P500 and the Total Stock Market indexes fall into the large blend category because they are dominated by a broad spectrum of large cap stocks. Here are the holdiings of the S&P500 as defined by Morningstar (7/10).

Composition of the S&P 500
Large Value – 29%
Large Blend – 30%
Large Growth – 29%
Mid Value – 5%
Mid Blend – 4%
Mid Growth – 4%
Small Value – 0%
Small Blend
– 0%
Small Growth –

Compare this to a profile of the total U.S. stock market (7200 stocks).

Composition of the total Market
Large Value – 24%
Large Blend – 24%
large Growth – 24%
Mid Value – 6%
Mid Blend – 6%
Mid Growth – 7%
Small Value – 3%
Small Blend
– 3%
Small Growth –

Some market segments act differently enough from one another or the overall market that they are called different stock asset classes. For instance, small value stocks as a group do not follow the movements of the large blend group. Large value (LV), Large growth (LG), Small value (SV) and Small growth (SG) are like different kinds of clothes and are called asset classes for purposes of diversifying stock. Blends of asset classes do conform to size, but distinctive value and growth characteristics are subdued.  These sub asset classes are just for stocks and should not be confused with the primary asset classes of stocks, bonds and cash discussed in the asset allocation section.

In addition to the four classes of stock mentioned, international stocks and REITs (Real Estate Investment Trusts, pronounced Reets) are also well recognized asset classes because they too act quite differently than the total U.S. stock market. There are other groups as well that some investors consider classes, but you can do very well with just those I’ve mentioned. Asset classes are the real key to diversification.  Owning two mutual funds in the same asset class does not  increase diversification.

Major Stock Asset Classes
Large value
Large blend/growth
small value
small blend/growth
International small
Emerging Markets

To give you an idea of how these asset classes fluctuate in performance take a look at the Callan Period Table of Investments.

The Bond Market
Like diversifying with stock funds, it is also wise to diversify with bond funds. Bonds are loans called debt instruments (DI). There are a large variety of them and they are categorized by type and quality. There are government treasury bills, notes and bonds, state bonds, municipal bonds and corporate bonds of short, intermediate and long maturity. There are treasury inflation-protected bonds (TIPS), tax-deferred bonds (I-bonds) and low-quality bonds know as hi-yield or “junk” bonds. When you purchase a bond you are essentially loaning money. There are two main concerns with bonds or bond funds: one is quality, and the other is duration. As with stocks, quality and risk are intertwined.

Treasury bonds are backed by the U.S. government and carry no loss of payment risk. Corporate bonds are issued by companies seeking needed money. These can be of very good quality or very risky. Lower quality equals higher yields and higher risk. Companies in poor financial shape have to offer higher interest rates or no one will loan them money, but the higher interest comes with the risk of the company failing to return the loan. Each bond has a quality rating and each bond fund has an average rating. Hi-Yield funds carry mostly all higher-risk, low-quality bonds that are often called “junk bonds.” Limit your riskier bond fund exposure to 10%-15%.

The other consideration with bonds is the duration. The price of a bond, once issued, goes up or down depending on interest rate changes. Duration provides a sensitivity measurement for how much the price might change with rate changes. The longer the duration of a bond, the more the price will fluctuate with interest rate changes. Link to Vanguard Interest Rates and Bonds.

Link to Vanguard paper on bonds and interest rate movement:

Link to Securities Industries and Financial Markets Association

The price of a bond already on the market fluctuates to keep the older bond competitive with new bonds that have different rates. For instance, the price of a 10 year bond that pays 4.0% will go down if a new 10 year bond comes out paying 4.5%. This is because no one will buy a bond paying 4.0% unless they can buy it at a discount. Bonds with higher rates are issued when the borrower can’t find enough investors to loan money at lower rates. Longer term bonds have higher yields, but they also have higher durations, which makes them more volatile than short and intermediate term bonds.

A bond fund has a mixture of many bonds maturing at different times so funds use an average maturity of short, intermediate or long term. And each fund will also have a duration. Durations range from about 2 for short term bonds to 8 or 9 for long term bonds. A fund with a duration of 4 means the fund’s net asset value (NAV) will go down 4% for each 1% interest rate increase and it will go up 4% for each 1% interest rate decrease. Inflation-protected bonds have a built in component that moves with interest rate changes so it protects the bonds from being worth less because of inflation.

Link to Morningstar bond tutorial –

Link to Treasury Inflation Protected Securities (TIPs) tutorial –

General Investment Risks In finance, risk has a number of different meanings. We have already examined the most basic definition in the asset allocation section – the chance the money won’t be there when you need it. A second type of risk is called specific stock risk. If an investor holds a high percentage of his money in one stock he holds a high risk of losing a lot of money if something goes wrong with the company. This type of risk is about a small chance of a major catastrophe. Something like your house burning down.

The chances of a fine company going bad is small, but if it happens. And if it does, the consequences will be big if most of one’s money is in that stock. This type of risk can be eliminated by holding many stocks, and that is one of the reasons for holding mutual funds. It’s kind of like fire insurance. In a fund of 100 stocks, one company crashing doesn’t create much of an impact. Be careful about putting too much into the stock of the company you work for. Most recommendations say to limit investments in one stock to no more than 5%. You might be able to stretch this some, but don’t ignore the long-shot possibility of unseen risk. Working for a company and holding it’s stock could result in a double wammy of job loss and asset loss.

Part II. Diversifying Your Investment Portfolio With Asset Classes – the core of the portfolio selection method.
Once you have set your overall asset allocation—the percentages in your portfolio assigned to stocks, bonds and cash—you can turn to diversifying your equity holdings with the sub asset classes of large value, large growth, small value, small growth, international, small international, emerging markets, and REITs. Diversifying with these different asset classes can provide some reduction of a another kind of risk called volatility.

Volatility is a risk which measures how much a fund’s returns might fluctuate. It is technically defined as standard deviation (SD). And standard deviation is a mathematical risk factor used for tracking the swings in returns for stocks, bonds, and funds. The bigger the SD number, the larger a fund’s returns may fluctuate.

Volatile Assets in a Portfolio
Portfolio volatility reduction occurs because the returns of the different asset classes do not move together. They do not correlate with each other. Combining asset classes with different volatilities has the effect of lowering the volatility of the overall portfolio. And diversification does something else that is quite remarkable: it can increase your returns given the same amount of volatility risk. As Larry Swedroe remarks in his book, “What Wall Street Doesn’t Want You to Know “Diversification of risk through the ownership of low-correlated assets is the only free lunch in investing.”

In the following example, 30% of small international is added to the S&P 500 and the overall volatility (SD) of the portfolio is lower than either of the two asset classes alone. And the returns are improved by 2% over the S&P500 alone. Example of asset class diversification, 1970-2002:

Asset class Return – (SD)

S&P500 10.8% – SD = 17.5
Small International 15.0% – SD = 30.1
Mix 70 S&P/30 Int. 12.8% – SD = 17.2

The S&P500 is a large blend/growth asset class and small international stock is a class of stock that doesn’t act like the S&P – It doesn’t correlate with the movements of the S&P500. In fact, one may be going up while the other is going down—that makes it a good diversifier. Small international is very volatile on it’s own. In statistical terms, the SD of 30.1 means that in any year the annualized returns of 15% might be anywhere between +45% and -15%, 67% of the time. The other 33% of the time the swings can be much more, even twice as much. In practical application, standard deviation (SD) can be viewed as a measure of unpredictability. in short time frames, the returns can vary widely. For instance, small international could have two or three years with returns of +35%, but in the year after you invest the return could be minus 10%. This is one reason why you should never invest in a fund based on past returns. And the higher the SD of a fund, the more unpredictability and the less you should hold. When investors diversify properly, one of two of their asset classes might be down at any given time while others are doing well. But which asset class might be favorable in the market changes from time to time and those changes cannot be predicted. This is like changes of weather on your trip. But if you are diversified, you will have a much better chance of having something in your portfolio that is outperforming.

Eric Tyson says in his book, Mutual Funds for Dummies “To decrease the odds of all of your investments getting clobbered at the same time, you must put your money in different types or classes of investments.”

Let’s try one other example, this one with REITs. Data from 1972-2003

Portfolio 1
Stocks 50%, Bonds 40%, T-Bills 10%, REITs 0%
Return = 10.9%, SD = 10.8%

Portfolio 2
Stocks 45%, Bonds 35%, T-Bills, 10%, REITs 10%
Return = 11.2%, SD = 10.4%

Portfolio 3
Stocks 40%, Bonds 30%, T-Bills 10%,
REITs 20%
Return = 11.5%, SD = 10.1%

Notice again that the returns go up and the standard deviation goes down. Data provided by T. Rowe Price Investor Magazine June, 2005

There you have it, the magic of asset class diversification in action. It is the different correlations interacting together that make it work. Correlations between asset classes are always changing to some degree due to different market forces, but that’s not something to be too concerned about. In the example above, the percentages of REITs won’t always give the listed returns and SD, but you can be sure diversification will be working at some level as long as you don’t add too much of the more volatile asset class.

Link to a good article demonstrating the positive effects of diversification

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