Why Variety Is Key in Building A Healthful Financial Diet
By Allen Pryor, CRPS

As you build your nest egg for retirement, your children’s or grandchildren’s education, or any other substantial goal, would you put all of your money into a single investment to reach these goals? Hopefully no more than you would go on a diet of your single favorite food if you wanted to stay healthy.

A diet of just one food would create unbalanced health in the same way that concentrating all your money in one type of investment can create an unbalanced and risky portfolio.

Just as a balanced diet of several food groups helps promote good health, a portfolio diversified across several different types of investments can help create good financial health. You want investments that perform differently from each other under different market and economic conditions, cushioning each other against the effects of market volatility. When some asset classes zig, you want others to zag to help level your portfolio’s overall performance.

Investors typically have at least three requirements: growth, safety and liquidity. Though it is rare to find one investment that gives you all three, the right combination can get you closer to the overall results you seek.

The Benefits of Asset Allocation
The most widely used method for putting together that right combination of investments is asset allocation.

Asset allocation guides what asset classes in what proportions belong in your portfolio, based on:

• your present financial status;
• the rate of return you need to reach your financial goals;
• the volatility you can tolerate along the way;
• your investing time frame;
• your need for liquidity.

Developing your own personal asset allocation model should be your first step before investing in anything. It’s your road map to help you stay on a disciplined, long-term investing track and not be thrown off course by short-term market events.

Investing Styles

There are two basic stock investing styles: value and growth. At any point in time, one style or the other will be in favor, or both styles could be in favor at the same time, but in varying degrees. Sometimes one style may be in favor for years. For example, for many years in the late ’90s, growth stocks had an edge.

• Value Investing: Value investing entails choosing stocks with unappreciated potential - stocks that may be out of favor with the market and priced cheaply but have sound fundamentals and are possibly poised for a turn-around. Value investing means searching for a company with a good future, but one that the market just hasn’t noticed yet. It means buying future winners before the market fully recognizes them and waiting for the market to see their true value.

Value stocks can be detected by one or more of these characteristics:

• Generally trading below their intrinsic values, or the true per-share value of the company based on what it could be liquidated for. Theoretically, stocks should, over time, trade in line with their intrinsic values.

• Financial ratios, such as price/earnings, price/sales, price/book value, price/cash flow and debt/capital, are typically lower than market indexes such as the Standard & Poor’s (S&P) or the Dow Jones Industrial Average (DJIA).

• Often a high dividend yield. These companies can be more oriented toward paying a dividend rather than reinvesting for growth.

• May have hidden value such as land, assets or property on the books at cost; patents; or lots of cash that other investors overlook.

• They have a lower growth rate than growth stocks due to the industry or maturity of sector.

• They are more responsive to the economy than growth stocks. An improving economy can spur improving earnings and drive up a stock’s price.

• They may be in out-of-favor industries, such as large-ticket capital equipment, which can experience sales and earnings drops when interest rates rise, or oil when world supply levels become too high and cause price drops.
Though Wall Street gives a lot of importance to a company’s financial numbers, such as quarterly earnings performance, value investors and value managers know it’s important to look beyond these numbers to assess a company’s prospects. If the cause for a company’s low stock price was a negative event, but there’s potential for a reversal, the stock may be viewed as an attractive buy.

Growth Investing: At the other end of the spectrum from the value style is growth investing.

Characteristics investors look for in a growth company are:

• High revenue and earnings growth

relative to the rest of the industry.

• An industry leader in sales and profits and often has the highest price/earnings ratio.

• Price that often escalates beyond the rate of earnings growth and drives price/earnings ratios out of proportion to the market.

• Dividend yields that are low because the profits are generally reinvested back into the company.

Growth investing focuses on current winner stocks you expect to continue their positive trends. Growth stocks usually perform well in a growing economy when their earnings are rising. They have also tended to outperform value stocks in up markets. Past performance, however, is no indication of future results.

Market Capitalization
Market capitalization, or “market cap,” is a measure of a corporation’s value according to the investor marketplace. It is calculated by multiplying the stock’s current price by the number of outstanding shares held by its stockholders. It is primarily used to classify and distinguish large companies from small and mid-sized companies.

Market cap, however, is only one measure of a company’s size. For example, a company with annual sales of $30 billion and 3 billion shares outstanding at a market price of $40 would have a market cap of $120 billion. Compare this with a much larger company that has six times the annual sales at $180 billion but only 600 million shares outstanding at $60, resulting in a market cap of only $36 billion, or less than one-third the market cap of the company with lower sales.

To the investor, a company’s market cap indicates how strongly invested a company is. Generally, the larger the market cap, the safer the company - but not always.

The following capitalization amounts are general guidelines for each category:

• Large Cap: The largest corporations, with a market cap greater than $10 billion.

• Mid Cap: Companies still small enough for rapid growth and not as heavily followed by the institutions as large-cap companies. They generally have strong liquidity and are typically more seasoned than small caps. Market cap is between $2 billion and $10 billion.

• Small Cap: Companies with market caps of less than $2 billion. As some of these companies grow and meet with success, they move into the mid- and large-cap categories, rewarding investors with substantial returns. However, during the last two decades, small-cap companies that remained in the small-cap category had a lower return and a greater risk than large-cap stocks. You can mitigate for some of this risk, however, by diversifying into other companies.

• Micro Cap: Companies with capitalizations of $300 million and below. Typically ignored by the institutions, they carry relatively high risk compared with larger-cap companies.

Within these capitalization ranges, companies can be classified as either value or growth.

Global Diversification
If all of your investments are within U.S. borders, you could be missing opportunities.

There are two basic approaches to investing in securities outside the United States:

• International: These are securities of foreign-market-based companies operating outside the United States. They include the many matured markets, such as Germany, France and Japan, and the emerging markets continually coming into being, such as Vietnam, Indonesia, Latin American countries and former communist bloc countries such as Poland and the Czech Republic.

• Global: A global portfolio includes international securities with a blend of U.S. securities.

There are risks associated with international investing, including currency, political, social and economic risks. Also, value and growth investment styles apply to foreign as well as U.S. stocks.

How to Diversify Your Portfolio
By constructing a blend of asset classes and styles, you can work toward meeting your own total return objectives and risk tolerance. You may even decide to forego one or two percentage points of potential return to reduce your risk and feel more comfortable with your portfolio.

Small-cap stocks had the highest average annual return during the 1975-1999 period, but they were also the most volatile. Treasury bills, at the opposite end of the risk/reward spectrum, had the lowest average annual return, but were the least volatile. All other asset classes fell somewhere between these two extremes.

Periodically Rebalance Your Portfolio
Volatile markets can quickly throw a portfolio off track. When one asset class overperforms, it can make the bottom line of the total portfolio still look acceptable. But if we ignore the underperformers and forget to keep all asset classes in balance with our asset allocation plan, it can mask a bigger problem.

Assume you have a $100,000 portfolio with 60% stocks and 40% bonds. Suddenly your stocks soar from $60,000 to $100,000, but your $40,000 in bonds stay flat. Result: A $140,000 portfolio with 71% stocks and only 29% bonds - perhaps more exposure to stocks than your asset allocation calls for.

To rebalance back to your original 60/40 allocation, you either need to prune and shift your stock winnings to bonds or leave the stocks alone and add new money to the bonds.

Review your portfolio at least annually and even more frequently in volatile markets. Asset allocation is not just for performance. It’s for risk-managed performance and to cushion the effects of volatile markets in your portfolio.

Mr. Pryor is a licensed financial consultant and Chartered Retirement Plan Specialist (CRPS) at A.G. Edwards & Sons, Inc., member of the Securities Investor Protection Corporation (SIPC). He can be reached at A.G. Edwards' Knoxville, Tenn., office at 800-688-2664, or via e-mail at allen.pryor@agedwards.com.