Diversifying a Portfolio with Asset Classes

Diversifying a Portfolio with asset classes

A good approach to diversifying with stock asset classes begins with viewing the U.S. equity portion of a portfolio. The total U.S. market profile is about 72% large cap, 19% mid cap, and 9% small cap (refer to the table on market organization in Ch. 3). Using this profile as a gauge gives you something to use as a comparison for your own individual portfolio holdings. Getting too far out of line with the market profile by adding a very large portion of one asset class may cancel the benefits of diversification and actually add additional volatility (SD). It will also introduce something called tracking error.

Tracking Error

Tracking error occurs when a portfolio that is much different from the market profile is used. Such a portfolio will not follow the movements or returns of the total stock market.

A non-conforming portfolio will at times have higher returns than the market, but it will also have lower returns at times. Inexperienced investors are quite pleased if their portfolio is beating the market, but many simply cannot stand to see the reverse. Having a portfolio that is down when the market is up causes many investors to abandon their strategy and change things, which hurts returns.

Portfolio Examples

The following portfolios are typical examples of those used by many investors, but they are not recommendations. What I’m trying to show is the process of developing a risk-controlled portfolio structured with recognized asset classes. It will be up to each individual investor to define their own risk profile and portfolio.

One of the simplest ways to build a portfolio is to use a mutual fund that tracks the entire market. A total market fund provides a lot of diversification because it has large cap value and growth stocks plus mid and small stocks in the exact proportion as the market. To further diversify, an investor should next add a total international fund. Usual recommendations for international exposure run from 20% to 40% of the equity allocation.

In the following examples all fund holdings add up to 100%. That is one recognized way of listing a portfolio. Viewing all accounts as part of the whole portfolio helps you get an overall view of everything you own. It also enables you to put assets in the most advantageous places.

Sometimes allocations are separated into percentages of stocks and percentages of bonds. Be sure you are clear on which way a portfolio’s holdings are being presented or recommended.

In the following example, total international is 20% of the equity allocation. Equity is 60% of the portfolio and 12 is 20% of 60.