With the end of the year in sight (amazing, isn't it?), it's a good time to review portfolio allocations. With the S&P 500 heading into the last few weeks of the year with an 11% gain, it's conceivable that your allocations are out of whack. In addition, the iShares Core U.S. Aggregate Bond ETF (AGG), which tracks the U.S. investment-grade bond market, is up 3.14% for the year.
Stocks and bonds are the basic portfolio building blocks, of course. But you can't stop there. That's where I have a gripe with people who just say something like, "It's good to a 60/40 stock/bond mix." That doesn't give you much to work with. You have to dig a little deeper.
I'll start with the categories of stocks that should be represented in your portfolio, and in my next column, I will move on to bonds.
Within the category of stocks, most Americans gravitate toward large-caps. Big American companies are familiar names, they get the most coverage by the media, and they are -- naturally -- the most actively traded. Therefore, they will always show up on "biggest mover" lists. Large-caps are often, but not always, less volatile than smaller stocks, and are more often dividend payers.
Plenty of research by the University of Chicago and Dimensional Fund Advisors, among other places, has shown that small-cap stocks, over time, deliver a better return than large-caps. Generally, stocks in this category have a market cap between $300 million and $2.5 billion. In the short term, they are often more volatile. That's because many are somewhat new and thinly traded, among other reasons. These days, I generally prefer owning small-caps in a mutual fund; spreading the risk is more palatable than betting the farm on Five Below (FIVE) in an effort to pick a small-cap that's been in rally mode lately.
Next up are growth stocks. Here's where things get a little thorny. This sounds, well "growthy," doesn't it? Unfortunately for investors who pile into growth stocks -- which are typically newer or smaller companies, or older companies having an earnings growth resurgence -- value stocks perform better, over time. If you want to check out some wonkish research on this subject, here's an article from Dimensional Fund Advisors.
You can think of growth vs. value in this way: Say you're buying a piece of rental property, and choosing between two locations. One has been remodeled and refurbished and has several interested buyers. The other needs new paint and carpets, and maybe some landscaping. Nobody is really interested. Which one do you think has the most headroom for appreciation?
That, in a nutshell, is why beaten-down value stocks, as a group, outperform growth stocks. Many of them are already trading at high multiples by the time the general public gets around to investing.
Finally, you have the broad category of foreign stocks, and here, it's crucial to make the distinction between stocks of developed and emerging nations. For example, developed European markets include many large-cap multinational firms, which, for all intents and purposes, are pretty much the same as S&P stocks. You could pick apart the differences between, for example, Novartis (NVS) and Pfizer (PFE), but you're essentially getting the same kind of sector exposure, and two similar, global pharmaceuticals.
However, when you're talking about emerging markets, that changes. Here, it's difficult (if not impossible) for U.S. investors to cherry-pick single stocks traded only on overseas exchanges. Sure, there are some ADRs, but how much are you really inclined to research an over-the-counter name such as Kuala Lumpur Kepong (KLKSY), and then give it a significant allocation in your portfolio?
That's what I thought. Clearly, this is a case where you buy the asset class via a fund, not via single stocks.
Emerging markets are another of those asset classes that over time (the key phrase) will deliver a superior return. However, as you might have guessed, they are also more volatile, meaning you must be prepared to sit through some volatility in this asset class, and not jump off the roller coaster! If you are near or in retirement, I would suggest ratcheting down the emerging market exposure significantly.