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Here’s a Better Way to Select Your Investments

Your equity asset mix should not be thrown together on a whim.

Pie charts

INVESTORS HAVE SEEN those pie charts that break down portfolio holdings according to asset class. At their most basic, they present two options: stocks and bonds.

That can be a very general guideline. For example, your financial plan may determine that an allocation of 60% stocks and 40% bonds gives you the best chance of achieving your financial goals.

But it’s not enough to simply say you’ll invest 60% of your portfolio in equities and the remainder in fixed income. Which stocks should you buy? Which bonds? Should you just guess? Look for tips online?

The problem with tips, hunches and guesswork is that you aren’t necessarily diversified. You are not likely to own securities that show different patterns of returns at any given time. If you own all large U.S. stocks, they are likely to behave in a somewhat similar manner. If you own all stocks from emerging markets, they, too, will tend to look similar.

That’s because members of one asset class, whether it’s large cap domestic stocks or something else, often move in the same direction at the same time. That may sound great when markets are zooming higher, but it’s not what you want when that inevitable correction rears its head.

There’s a better way to select your investments.

Not all stocks are the same. It takes some planning to make sure you have the right assortment of securities within your portfolio. That’s where asset classes are important. Asset classes are just a group of securities with comparable characteristics. For example, the Dow Jones Industrial average consists of large U.S. companies. These are some of the world’s biggest publicly traded firms and the companies are all subject to the same U.S. regulations.

As another example, emerging market equities are issued by firms in countries that typically have fewer regulations when it comes to capital markets and banking systems.

Here are several stock asset classes to include in your allocation:

  • Growth stocks
  • Value stocks.
  • Large cap stocks
  • Small cap stocks
  • Overseas stocks

Growth Stocks

This is generally a company that is on a fast track to a higher earnings and revenue. Often, tech companies fall under this category.

Growth stock investors understand these stocks are expensive, relative to their current book value and earnings. However, the hope is that the company will grow into its valuation.

Value Stocks

These are stocks of companies that are trading at a discount, relative to earnings and company book value. These can be companies whose price is beaten down, due to a company-specific event or because the entire industry is out of favor.

Investors buy these stocks with an eye on future performance. Over time, value stocks outperform growth, as they often have further room to run higher.

Large Cap Stocks

These are companies with a large market capitalization. You can determine a company’s market capitalization by multiplying the shares outstanding by the price per share.

Microsoft is currently the company with the largest market cap, which stands north of $1 trillion. These large companies tend to be more stable than their smaller peers, but that doesn’t mean they aren’t prone to sharp price declines at times.

The threshold for large cap is a value of around $2 billion or more.

Small Cap Stocks

Many publicly traded companies have a total market value between around $300 million and $2 billion. These are considered small caps.

These smaller companies are often more nimble, since they are newer and have fewer layers of management. They often have products or services that are in high demand.

Historically small caps have tended to return more than larger companies, although that is not true during all time periods.

Overseas Stocks

In recent years, U.S. stocks have outperformed large companies, but that’s not always true. During the 10-year period between 2000 and 2009, non-U.S. equities notched stronger performances than the S&P 500.

Because no one can accurately predict when one global region will outperform another, it’s prudent to hold both domestic and international stocks in your portfolio at all times.

Overseas stocks can further be divided into developed markets – those with well established banking and financial systems – and emerging markets, which were noted above as having less stable or well regulated banks and capital markets.

Your equity asset mix should not be thrown together on a whim. Instead, take your time to determine how each one, and in what proportion, fits into your financial plan.

Even better, ask a financial planner to devise the proper portfolio for your unique set of circumstances, which includes your time horizon, goals, risk tolerance and any other relevant factors.

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Better Money Decisions