We talk a lot about diversification, both in the context of the stock market and broader investing. Today I want to dig deeper into stock market diversification. Particularly I’d like to define some of the different asset classes of index funds and what they might mean for a diversified portfolio. We will start with the S&P 500.
How Do You Think About the Stock Market?
Before we talk about the specific classification of parts it’s important to understand how most people think of stock market investing. Most index investors think about the stock market as the S&P 500. What is the S&P 500 you ask? Well the S&P 500 is just a collection of 500 stocks representing large US companies. Now people generally assume that this index represents much of the US economy. But does it?
Asset Class By Company Size
To answer that question we need to dig deeper. Let’s start with the size of a company. In general, most people define a company’s size, whether it be large, medium, or small, by its market capitalization. In general market capitalization is a measure of company size as the price of a stock multiplied by the number of shares of the company that exist.
Remember the price of a stock has a relationship to its underlying value. So in essence company size is a proxy measurement to determine what company is the most valuable. The S&P 500 contains 500 of the largest companies in the US by market capitalization. So the S&P 500 is 500 of the most valuable companies in the US.
There is another index, the Dow. The Dow is designed to also manage 30 large US stocks. This is a separate set of stocks with some overlap to those of the S&P 500. The real difference between the two being the Dow is 30 stocks and the S&P is 500. So the S&P 500 is a broader representation then the Dow. Broader potentially means more diversified.
Sampling and How Many Stocks to Represent the Whole
A note, a stock index need not hold every stock of a given size or delineator to perform as a whole. Usually, sampling is used to get a broad enough set of stocks to perform like the whole. This is called sampling and is a common statistical method. So while 30 stocks as in the DOW is probably not a sufficient sample of large-cap stocks, one need not hold every large stock to represent large-cap stocks. Just a decently large sample size to be statistically significant needs to be randomly chosen. In theory, the S&P 500 meets this criterion for representing large caps.
Small-Cap and Mid-Cap Asset Classes are Not In the S&P 500
But still, the S&P is only a representation of large stocks. What about small and mid-size companies? Well for that you need additional indexes. The S&P 500 does not cover those. There are many indexes at the small and mid-size company level. Unlike large-cap where there are 2 US-based indexes that largely are considered to be the standard, mid and small caps have no standard. So similarly to the Dow versus the S&P 500 they can differ by breadth and makeup.
In general, if you really want a diversified portfolio you should hold assets in each set of company sizes. Today’s small companies may one be tomorrow’s mega corps. If you don’t have money invested in them today then you are missing all that potential gain. So now we must move beyond the S&P 500.
Total Stock Market Funds
If you buy something like total stock market what you are getting is some sort of collection of index funds representing all stocks in a given country. This is usually done via some form of market capitalization again. So large companies tend to represent a bigger piece of a total stock market index fund. This form of investing is probably best for your average investor.
Tilting Asset Classes
Should you believe that one of these other investment categories will outperform their size weighting in the total index you do what is called Tilting. Essentially you can buy indexes that focus on specific sizes of stocks to increase your exposure for that size beyond its market capitalization weight. There is some evidence that small caps particularly tend to outperform large caps for large periods. I tend to tilt, or buy more of, the small-cap class of stocks.
One additional note here, from my experience there is a clear delineation from small to large-cap. The definition of mid-cap seems to depend on where the indexing company draws an imaginary line. As such it’s a bit more nebulous.
Market Segment Asset Classes
So that is generally how index funds are allocated for the US. But that is not the end of the story. Many indexes are also cut by market segment. A market segment represents a type of company. This could be conglomerates, industrials, utilities, financials, tech, or any number of other logical groupings. It could even mean ethical versus non-ethical.
These groupings are set by whichever company created the specific index. In general, you would use these if you expected a particular area of the US economy to expand faster than others. Perhaps you expect Tech is overvalued. Or perhaps in a flight to safety moment you move to utilities. I do not segmentize my investments by company type. Honestly, this gets very close to market timing. I have no faith that I could consistently pick an industry that would outperform other industries.
Type of Business Asset Classes
I’d be remiss if I didn’t mention one more type of segment. This is the type based on the business type. The most common here is a REIT based stock. Beyond the scope of this post a REIT, in general, has a heavy focus on real estate. It is also subject to special tax laws around how it pays out profits. In general, you would invest in a REIT if you want to increase your exposure to real estate through the stock market. It is however debatable whether a REIT in the stock market is consistently diversified from the broader stock market since it is a component of the broader market.
Market Segmentation and Our Portfolio
I largely do not segmetize my market holdings. I do hold a REIT index in a small proportion. However, as noted previously I am in the process of determining a Real Estate Crowdfunding position to replace this real estate exposure. Once I have clearly vetted all real estate options I will complete that move.
Country Asset Classes
So that really does it for the US. But what about the rest of the world? Well, like the US the rest of the world can be split by market size. That being said most international index funds you will encounter tend to be focused more on large-cap internationals. The reality is it can be very expensive to invest in smaller companies internationally. There are a few small-cap international funds, but I’d say it is far less common. I do hold one small portion of international small caps. However, this is nearly inconsequential to the whole of my portfolio. For the sake of portfolio simplicity, I may someday dump this in favor of the more traditional international large cap index.
Developed Versus Emerging Markets
Instead, international funds tend to be split fairly evenly between developed and emerging markets. The idea is that the developed markets are more open, diversified, transparent, and have clearly defined rules. These represent western countries that tend to have been industrialized for a long time. In essence, their markets have many of the same risks as the US. To this is potentially added diversification of headquarters location.
I have written in the past that I hold a significant developed market tilt. Why? Headquarters location is not the same thing as customer revenue location. A company like Nestle is getting much of its revenue from the same regions as Hershey. However, unlike Hershey, it sits on a non-US market to which the S&P 500 does not cover. It is my belief that due to regional biases investors underprice certain regions despite their revenue being subject to largely the same exposures as multinationals in the US.
Some large caps do get their regional revenue in line with their headquarter location. In that case an international developed world allocation does add currency and legal exposure beyond the S&P 500. However, my view is the exposure is minimal.
Emerging markets are another story. Essentially, Emerging markets are those up and coming countries where they are now beginning to industrialize. I have gone on record as stating I avoid emerging markets. To the developed market risks we add significant issues with financial transparency, shifting rules, and laws against foreign investors.
This exposes you to more concerns like stock market swindles. In some cases emerging countries in the past have gone so far as to nationalize private industry. The government essentially takes ownership and leaves the stockholders with nothing. There is some significant risk here, beyond my personal risk tolerance. However, if you like potential outsize returns and are happy with signficant volatility then have at it.
Value Versus Growth Asset Classes
Finally, within both international and US-based holdings, we have one more type of segmentation, that of stock type. The concept here is known as value versus growth stocks. Value stocks are those that are considered to be underpriced. That is their price compared to their earnings, book value, or whatever is low. Warren Buffet is the most common name associated with this type of investing. The problem is, low valuation can occur for a number of reasons. It could be the stock is underpriced by investors. But it could also be the underlying company has significant issues ahead. IE Value stocks can mean great opportunity or a falling knife.
Growth stocks meanwhile are those of companies expected to grow their revenue or profits significantly over the next few years. The idea here is today’s price may be too little because the underlying business will be worth so much more a few years in the future. The problem here is that future growth is not guaranteed. So you are buying on the what if. These typically tend to be the stocks with the highest Price per earnings. Stated another way, these are the stocks that are most likely to be seen as in a bubble or overvalued. In some cases, the growth would have to be perfect to achieve expectations.
My Play Portfolio Uses Value Investing
I have talked about my play portfolio in the past. I do a little bit of value investing in my play portfolio. There is definitely an aspect of market timing so my likelihood of success is low. But I enjoy having at least a few potential home runs in my portfolio to tinker with. I do not generally invest in growth stocks as by the time I identify good targets they tend to already exceed my future expectations of price.
So there you have it, an understanding of stock classes and indexing. You can read more about our asset allocation here. Which classes of stock do you invest in?