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Constructing a Diversified Stock Portfolio by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research July 8, 2008 Updated from the Summer 2008 edition of On Investing, a magazine for Schwab clients. In How Many Stocks Should Be in Your Portfolio, we showed you that concentrated portfolios of 20 stocks or fewer are usually highly volatile and can't be expected to provide higher returns. Therefore, to minimize the impact of stock-specific risk, we recommended owning at least 40 stocks—far more positions than most investors hold. Here, we'll share Schwab's best practices for properly constructing a diversified stock portfolio. Managing overall portfolio risk The most general definition of investment risk is "return volatility through time." Asset allocation is your most important decision when managing overall portfolio volatility. For example, a measured blend of stocks (domestic and international), bonds and cash tends to provide a higher level of return per unit of risk exposure than an all-stock portfolio. Consequently, it's better to reduce the overall risk of an all-stock portfolio by allocating part of the portfolio to bonds rather than by trying to invest only in less-volatile stocks. Managing equity portfolio risk After targeting your overall portfolio risk level via asset allocation, you can turn to managing risk within your individual stock portfolio. The primary objective is to manage volatility relative to your benchmark so that your stock portfolio generally moves with or "tracks" the stock market. In the previous article, we showed that a randomly selected portfolio of 40 stocks historically has tracked the market with an annual standard deviation (a statistical measure of relative volatility) of only 5.3%. Conversely, a five-stock portfolio historically tracked the market with a shocking annual standard deviation of 23.8%! To reduce relative risk, we suggest aligning your portfolio with your benchmark along the two most critical dimensions of relative risk: company size and company sector. Company size as a risk dimension Equity market indexes are usually capitalization weighted, meaning that a $20 billion stock's contribution to an index's return is 10 times that of a $2 billion stock. But the size range among stocks within most indexes may come as a shock. For example, the largest 50 stocks (current market capitalization greater than $49 billion) comprise about 49% of the S&P 500 Index's total weight and the largest 250 stocks (capitalization greater than $11 billion) are about 88% of the index. The research tools on Schwab.com currently define "large-cap" stocks as those above $12.5 billion in market cap. By this definition, less than half of the stocks in the S&P 500 are even large-caps!  The market's top-heavy capitalization profile has huge practical implications for constructing a portfolio that tracks the S&P 500 Index. For simplicity, most investors tend to hold portfolio positions of approximately equal size. Imagine you had the wealth to hold an equal dollar amount in every S&P 500 stock. Your portfolio would track the S&P 500 Index reasonably well, right? Wrong! The chart above shows that an equal weighted portfolio doesn't track the S&P Index closely at all. For example, your portfolio would have lagged the S&P Index by 18.5% for the year ending January 31, 1999, yet it would have beat the S&P Index by 28.1% for the year ending February 28, 2001 (the tech bubble peak). That's huge relative risk from the same 500 stocks simply held in different proportions! Company sector group as a risk dimension The stock market can also be decomposed by sectors/industries. The S&P Global Industry Classification System (GICS) is commonly used to classify stocks into groups. The highest GICS aggregation level splits the market into 10 economic sectors (see the table below). This is important because stocks within the same sector often move together, while the sector groups themselves often move somewhat more independently.
As a result, two portfolios with the same number of stocks can perform very differently if their sector compositions differ. Lured by thematic investing stories, investor portfolios often become overrepresented in hot market sectors at just the wrong time. For example, many investors painfully experienced the risk of being overweighted in technology stocks when the tech bubble burst back in 2000–2002. Schwab research has found that simply matching a portfolio with sector weightings to a benchmark typically reduces relative risk by a quarter without reducing average returns. Constructing a diversified equity portfolio The lesson to learn is that market leadership rotates unpredictably through time—between larger-cap and smaller-cap stocks and among stocks in different economic sectors. Fortunately, you can largely avoid getting whipsawed and more closely track a benchmark like the S&P 500 by constructing your portfolio to be approximately "sector neutral" and "capitalization neutral" relative to the index.
Note: Don't fret about precisely matching the benchmark's sector and capitalization composition—close usually gets the job done. Properly diversifying your stock portfolio is time well spent because it reduces expected risk without reducing expected returns. Of course, if you don't have the capital or commitment to construct and manage a large stock portfolio, mutual funds or exchange-traded funds (ETFs) can be fine alternatives. Fortunately, the tools on Schwab.com are designed to make the portfolio management task easier. Schwab clients can use our stock screener and stock lists to look for stock ideas by market-index capitalization, sector groupings and Schwab Equity Ratings. Clients can also run a Portfolio Checkup report at any time to monitor their portfolio's market capitalization and sector diversification. Important Disclosures The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Examples provided are for illustrative (or "informational") purposes only and not intended to be reflective of results you can expect to achieve. (0708-4170) Return to Top |
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