Slicing Up the Stock and Bond Pies

Step 2: Why Should I Diversify Between Large Stocks, Small Stocks, and Foreign Stocks?

The largest segment of the stock market (measured by market capitalization—share price times number of shares outstanding) consists of large, well-established companies. The Standard & Poor's 500 usually defines this group; it represents nearly 80% of the U.S. stock market. Most of these companies are well-known names: Microsoft, Ford and AT&T, for instance. The stocks of these firms offer good growth potential, since they grow as the economy expands. They also offer some income, since they tend to pay cash dividends. These companies should form the core of every investor's stock portfolio.

There are two other stock market segments, however, that should not be ignored: small-company stocks and foreign firms.

The stocks of smaller U.S. companies in general have a greater potential for long-term growth than large, well-established companies. However, they also have greater risks. In addition to the risks associated with stocks in general, the stocks of smaller firms have these further risks:

• There may be no yearly income stream, since they do not tend to pay dividends.
• It can be harder to obtain information about specific firms, making accurate analysis difficult.
• Their returns tend to be much more volatile, with firms more prone to difficulties during economic downturns.
• Because they have a smaller number of shares outstanding, these stocks tend to be less liquid, making buying and selling more difficult.

While smaller-company stocks tend to be more volatile than the stocks of larger firms, studies indicate that their average long-term returns have been greater. If you have a long-term horizon, the addition of small stocks to a core portfolio of larger firms can increase your overall stock portfolio return, if you are willing to take on the extra risk of greater return swings year to year.

The other market segment consists of the international market—foreign firms located in Japan and Europe and, to a much lesser degree, the emerging markets of Asia and Latin America.

Foreign stocks have these additional risks:

• Currency risk: The risk that changes in the relative value of the dollar and the currency of the country in which the firm is based will affect an investor's return. Currency risk is one reason returns for foreign firms are so volatile.
• Country risk: The risk that political conditions within a country will affect economic conditions.
• Many foreign company stocks offer little or no annual income.

Foreign stocks offer substantial diversification benefits because they tend to be affected by different economic factors than the U.S. markets. The zigs and zags in return in these stocks do not always coincide with those of U.S. stocks.

An example of how these three market segments have behaved over the last 20 years is presented in Table 1. The table presents the average returns for three indexes: the S&P 500, representing the stocks of larger companies; the MSCI EAFE index, representing international stocks; and the Russell 2000, an index representing the stocks of smaller firms.

The yearly return figures illustrate the higher risk of foreign and smaller firm stocks--small-cap stocks had more yearly losses than did large-cap stocks, and the losses for both international stocks and small-company stocks can be larger than for large-cap stocks. The figures also illustrate the higher potential returns.

The last three rows illustrate the benefits of adding the two market segments to the large-company stock portfolio. For example, the Conservative portfolio consists of 80% invested in large-cap stocks, 10% in small-cap stocks, and 10% in international stocks. The first Aggressive portfolio has 40% invested in small-cap stocks, while the second Aggressive portfolio has 40% invested in international stocks. There is, of course, an endless array of combinations; these are presented only as examples. The yearly return figures for the combination portfolios compared to the individual market segments provide an indication of the benefits of a mixture.

What about the overall returns? The cycles that favor one market segment over another can extend over long time periods. The 1996 to 2005 period favored small-cap firms, while the 2006 to 2015 period favored large-cap firms. However, over the entire period the combination portfolio are less volatile than any of the market segments. It is the uncertainty concerning these patterns that creates risk; by diversifying among these various market segments, you are reducing the risk that you will guess the pattern incorrectly.

Table 1. Stock Market Segments

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