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The Portfolio Pyramid: How to Diversify Your Investments by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc. October 12, 2007 Remember the food pyramid for building a balanced diet? The portfolio pyramid covers the essential elements of a healthy, balanced portfolio. The portfolio pyramid is a way of looking at your portfolio to determine if it's truly diversified both across and within asset classes. As you can see below, the pyramid breaks down a portfolio into manageable layers, making it easy to uncover any unhealthy symptoms. The portfolio pyramid  Here, we'll primarily go through the side of the pyramid that has to do with stocks, though the bond side is just as important. Asset allocation: the foundation of your portfolio The foundation of the pyramid is asset allocation. Your asset allocation determines the broad risk level of your portfolio, which should match your risk profile. This is where Schwab's model asset allocation plans come in. They cover the spectrum of risk by combining different asset classes: large-cap and small-cap U.S. stocks, international stocks, bonds and cash. Schwab's model asset allocation plans1 
As of: October 5, 2007. Asset allocation plans are subject to change without notice. Please contact your Schwab consultant for the latest information. Once you've diversified across asset classes, you can start diversifying within asset classes. Market capitalization The size of a company is often measured by its market capitalization—the company's stock price multiplied by the number of outstanding shares. On the pyramid, market cap denotes the percentage of large versus small companies in the stock portion of your portfolio. Small-cap stocks tend to be riskier than large-caps, but have the potential for more upside. A sound diversification plan includes both, because nobody knows which of these two asset classes will be in favor at any particular time. For example, in 1998, domestic large-caps2 outperformed small-caps by 31 percentage points. But in 2003, small-caps outperformed by 19 percentage points. Style Next up is style, or the balance between growth and value investing. We recommend a mix of both. Again, the difference in performance can be dramatic. For example in 1999, small-cap growth outperformed small-cap value by 44 percentage points. But in 2000, that was reversed and small-cap value outperformed by 44 percentage points.3 Styles respond to markets differently3  Sector Every stock is in an industry, and every industry is in a market sector. Holding too many investments in the same sector can be risky. As the chart below shows, the information technology sector saw greater single-year gains, but also saw heftier single-year losses from 1990 to 2006. Sectors tend to be riskier than the broad market4 Range of annual returns, 1990-2006  Industry Jumping up to the next layer in the pyramid, the 10 sectors comprise 67 industries and 147 subindustries. Even when a sector's performance is up, not all industries within that sector will perform identically. In 2006, the consumer discretionary sector was up 17%. Yet if we look closer at this sector we find it contained 31 different subindustries which had a mixed performance. Two notable examples are the 36% loss in educational services and the 43% gain in broadcasting and cable TV.5 Depending on what industry you held within the sector, your return could have been quite different. The lesson? For a balanced diet, after you diversify across sectors, diversify across the industries within a given sector. Geography Over the past 37 years, the U.S. has a 0-37 record as the best performing market in a single year. This shows that you should to look at investment opportunities outside the U.S. As with sectors and industries, your portfolio should include a mix of different countries. For example, the Morgan Stanley All Country World index includes 50 developed and emerging markets around the globe. Manager Next comes managing your managers. It can be risky to have all of your actively managed mutual funds with the same portfolio manager. Suppose the portfolio manager leaves the firm? Or the fund company goes through a disruptive restructuring? How might changes like these affect your portfolio? Hence, it makes sense to diversify across managers, as well. Stock Finally, at the top of the pyramid, we have the individual stock level. This is where your greatest risk likely resides. As you create your portfolio be watchful of inadvertently concentrating your position in a single firm. Remember the tragic headlines of Enron employees who suffered great losses in their retirement plans? That's because they were over-concentrated in Enron stock. Enron is not an isolated incident. Many supposed blue chip companies have imploded in their day—Conseco, Kmart, WorldCom, and United Airlines to name a few. To reduce the risk of that type of portfolio meltdown, diversify your stock holdings so that no more than 20% of your portfolio is represented by any one stock (including stocks held in mutual funds). Generally, you need 40–50 stocks for adequate diversification—which means if you have less than $50,000 to invest, you might want to consider mutual funds. Investing in mutual funds can be a convenient, cost-effective way to diversify your stock holdings. You might still choose to own individual stocks. If you do, pick those stocks carefully—Schwab Equity Ratings® can help—because not all stocks move like the market. In 2002, when the S&P 500® index was down more than 20%, 131 of the 500 companies had positive performance. And in 2006, when the market was up over 15%, nearly a quarter of the companies in the index had negative performance. Not all stocks move like the market6
Is your portfolio truly diversified? Remember, you need balanced servings from the many investment categories to build a healthy portfolio. Using the portfolio pyramid, you can go through your portfolio layer by layer and see what it takes to truly diversify across and within asset classes. If you'd like to talk to a professional, give a Schwab Financial Consultant a call at 800-435-4000. Important Disclosures Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling 800-435-4000. Please read the prospectus carefully before investing. Investment value will fluctuate, and shares, when redeemed, may be worth more or less than original cost. 1. Source: Schwab Center for Financial Research with data provided by Ibbotson Associates, Inc. The return figures for 1970 through 2006 are the average, the minimum and the maximum annual returns of the hypothetical asset allocation plans. The asset allocation plans are weighted averages of the performance of the indexes used to represent each asset class in the plans, include reinvestment of dividends, and are rebalanced annually. The indexes representing each asset class in the historical asset allocation plans are S&P 500 Index (large-cap stocks); CRSP 6-8 Index (small-cap stocks); MSCI EAFE net of taxes (international stocks); Ibbotson Intermediate U.S. Government Bond Index (bonds); and 30-day Treasury bills (cash). 2. In this example and the next, domestic large caps are represented by the S&P 500® Index, while small caps are represented by the Russell 2000 Index. 3. Source: Schwab Center for Financial Research with data provided by Ibbotson Associates, Inc. The indexes representing each asset class are as follows: Russell 1000 Growth Index (large growth), Russell 1000 Value Index (large value), Russell 2000 Growth Index (small growth), Russell 2000 Value Index (small value). All returns are annualized and assume reinvestment of dividends. 4. Source: Schwab Center for Financial Research with data provided by Standard & Poor's. The chart compares the volatility of the market, as represented by the S&P 500 Index, to the volatility of S&P GICS sectors. The highest and lowest annual total returns for each sector were chosen to depict the volatility of the sectors for this period (1990-2006). Returns assume reinvestment of dividends. The S&P 500 is a capitalization-weighted index of 500 stocks from a broad range of industries. The Global Industry Classification Standard codes (GICS) consist of 10 economic sectors aggregated from 23 industry groups, 67 industries and 147 subindustries covering over 34,000 companies globally. 5. Source: Schwab Center for Financial Research with data from Ibbotson Associates, Inc. and Standard & Poor's. GICS sector and subindustry index total returns for 2006 include reinvestment of dividends. 6. Source: Schwab Center for Financial Research with data from Standard and Poor's. Total return includes reinvestment of dividends. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results. Small-cap stocks are subject to greater volatility than other asset categories. International investments are subject to additional risks, including differences in financial accounting standards, currency fluctuations, political instability, foreign taxes and regulations, and the potential for illiquid markets. Investing in sectors may involve a greater degree of risk than an investment in other securities with broader diversification. The Schwab Center for Financial Research is a division of Charles Schwab and Co., Inc. Investment strategies, including diversification, do not assure a profit and cannot protect against losses in a declining market. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed. (1007-6872) Return to Top |
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