The Portfolio Pyramid: How to Diversify Your Stock Investments
February 8, 2013
Key Points
- Just as the food pyramid suggests a well-balanced diet, the portfolio pyramid covers the components of a healthy, balanced investment portfolio.
- Here, we focus primarily on the side of the pyramid having to do with stocks.
- The foundation of the portfolio pyramid is asset allocation, which determines the broad risk level of your portfolio to match your risk profile.
Remember the food pyramid for building a balanced diet? The portfolio pyramid covers the essential elements of a healthy, balanced investment 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 equally 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- and small-cap US stocks, international stocks, bonds and cash investments.
Schwab's Model Asset Allocation Plans1
| Conservative | Moderately conservative |
Moderate | Moderately aggressive |
Aggressive | |
| Stocks | 20% | 40% | 60% | 80% | 95% |
| Large-cap | 15% | 25% | 35% | 45% | 50% |
| Small-cap | 0% | 5% | 10% | 15% | 20% |
| International | 5% | 10% | 15% | 20% | 25% |
| Bonds | 50% | 50% | 35% | 15% | 0% |
| Cash investments | 30% | 10% | 5% | 5% | 5% |
| Average annual return (1970-2012) |
8.0% | 9.1% | 9.6% | 9.9% | 10.0% |
| Best year (1970-2012) |
22.8% | 27.0% | 30.9% | 34.4% | 39.9% |
| Worst year (1970-2012) |
-4.6% | -12.5% | -20.9% | -29.5% | -36.0% |
| Number of years with losses |
1 | 6 | 7 | 9 | 10 |
| Average losses in down years |
-4.6% | -4.4% | -8.5% | -11.0% | -13.4% |
As of: January 27, 2013. 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 2007, domestic large-caps2 outperformed small-caps by seven percentage points. But in 2010, small-caps outperformed by 12 percentage points.
Style
Next up is style, or the balance between stocks with a greater-than average growth orientation and value- (stocks with a less-than average growth orientation) investing. We recommend a mix of both. Again, the difference in performance can be dramatic. For example, in 2008, small-cap value outperformed small-cap growth by 10 percentage points. But in 2009, that was reversed and small-cap value outperformed by 14 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 underperformed three other sectors on average from 1990 to 2012.
Sectors tend to be riskier than the broad market4
Range of annual returns. 1990-2012
Industry
Jumping up to the next layer in the pyramid, the 10 sectors comprise 65 industries and 134 subindustries. Even when a sector's performance is up, not all industries within that sector will perform identically.
In 2012, the consumer discretionary sector was up 22% (excluding dividends). Yet if we look closer at this sector we find it contained 32 different subindustries that had a mixed performance. Two notable examples are the 60% loss in educational services and the 114% gain in household appliances.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 43 years, the United States has a 0-43 record as the best performing developed market in a single year, according to data from Morningstar, so you may wish to consider investment opportunities outside the United States. As with sectors and industries, your portfolio should include a mix of different countries. For example, the Morgan Stanley Capital International All Country World Index (MSCI ACWI) includes 45 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 Lehman Brothers employees who suffered great losses in their retirement plans? That's because they were over-concentrated in company stock. An Lehman Brothers wass not an isolated incident—many supposed blue-chip companies have imploded in their day—Enron, 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 22%, 131 of the 500 companies had positive performance. And in 2012, when the market was up 16%, nearly a quarter of the companies in the index had negative performance.
Not All Stocks Move Like the Market6
| Year | S&P 500 return | Number of stocks down | Number of stocks up |
| 2012 | 16.0% | 107 | 390 |
| 2011 | 2.1% | 265 | 232 |
| 2010 | 15.1% | 109 | 390 |
| 2009 | 26.5% | 73 | 425 |
| 2008 | -37.0% | 470 | 25 |
| 2007 | 5.5% | 246 | 245 |
| 2006 | 15.8% | 120 | 369 |
| 2005 | 4.9% | 213 | 286 |
| 2004 | 10.9% | 120 | 378 |
| 2003 | 28.7% | 41 | 458 |
| 2002 | -22.1% | 368 | 131 |
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.
Next Steps
Talk to us about portfolio planning. Call 800-435-4000 or visit a branch near you.
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 Morningstar, Inc. The return figures represented are the compound average, minimum, and maximum annual total returns of 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 and are rebalanced annually. Returns include reinvestment of dividends and interest. The indexes representing each asset class are S&P 500® Index (large-cap stocks), Russell 2000® Index (small-cap stocks), MSCI EAFE® Net of Taxes (international stocks), Barclays U.S. Aggregate Index (bonds) and Citigroup US three-month Treasury bills (cash investments). CRSP 6-8 was used for small-cap stocks prior to 1979, Ibbotson Intermediate-Term Government Bond Index was used for bonds prior to 1976 and Ibbotson US 30-day Treasury Bill Index was used for cash investments prior to 1978.
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 Morningstar, 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 (1990-2012). Returns assume reinvestment of dividends. The Global Industry Classification Standard codes (GICS) consist of 10 economic sectors aggregated from 24 industry groups, 65 industries and 134 subindustries covering more than 40,000 companies globally.
5. Source: Schwab Center for Financial Research with data from Morningstar and Standard & Poor's. GICS sector and subindustry index total returns for 2012 include reinvestment of dividends.
6. Source: Schwab Center for Financial Research with data from Standard and Poor's. Total return includes reinvestment of dividends.
Barclays U.S. Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more.
Citigroup U.S. 3-month Treasury Bill Index is an index that measures monthly total return equivalents of yield averages that are not marked to market. The Three-Month Treasury Bill Index consists of the last three three-month Treasury bill issues.
CRSP 6-8 Index is a small-cap index created and maintained by the Center for Research in Security Prices (CRSP) at the University of Chicago's Graduate School of Business. CRSP capitalization-based indices include common stocks listed on the NYSE, AMEX, and the NASDAQ National Market. The CRSP 6-8 Index refers to the 6th through the 8th deciles and represents a small cap index that excludes micro-caps.
Ibbotson U.S. Intermediate-Term Government Bond Index is constructed from monthly returns of non-callable bonds with maturities of not less than five years, held for the calendar year.
MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 45 country indices comprising 24 developed and 21 emerging market country indices. The developed market country indices included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States. The emerging market country indices included are: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the US & Canada. The MSCI EAFE Index consists of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.
Russell indices are market-capitalization weighted and subsets of the Russell 3000® Index, which contains the largest 3,000 companies incorporated in the United States and represents approximately 98% of the investable U.S. equity market. The Russell 2000® Index is composed of the 2000 smallest companies in the Russell 3000 Index. The Russell 2000® Growth Index contains those Russell 2000 securities with a greater-than-average growth orientation. The Russell 2000® Value Index contains those Russell 2000 securities with a less-than-average growth orientation. The Russell 1000® Growth Index contains those Russell 1000 securities with a greater-than-average growth orientation. The Russell 1000® Value Index contains those Russell 1000 securities with a less-than-average growth orientation.
S&P 500® Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity, and industry group representation.
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.
Schwab Equity Ratings and the general buy/hold/sell guidance are not personal recommendations for any particular investor or client and do not take into account the financial, investment or other objectives or needs of, and may not be suitable for, any particular investor or client. Investors and clients should consider Schwab Equity Ratings as only a single factor in making their investment decision while taking into account the current market environment.
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.