You have likely heard the saying “don’t put all your eggs in one basket.” In the investment world, we use the term diversification when we talk about spreading those proverbial eggs out into different baskets. Diversification is a method of reducing a portfolio’s level of risk while seeking to maintain the expected returns of your investments. 

While most investors are familiar with the concept of diversification, the “D” word can mean different things to different people. Investors can diversify across sectors, countries, asset classes, and many other factors. In this article, I am going to focus on another method.

Morningstar, an industry leader in investment research and portfolio design, has popularized a tool called the “equity style box.” This tool shows what types of companies are held inside a mutual fund or ETF. It breaks down companies according to two fundamental properties: size and investment style. Imagine a tic-tac-toe board, with company size running from top to bottom and investment style running from left to right.

Publicly listed companies will generally fall into one of three size categories: large-cap, mid-cap, or small-cap. As the names suggest, large-cap companies tend to be the biggest, with valuations of $10 billion or more. Mid-caps are usually valued between $2 billion to $10 billion, while small-caps can be anything from $300 million to $2 billion (those are rough numbers, as different experts may use slightly different values to define those spaces).

Companies are also classified as “value”, “growth”, or “blend.” Value companies are stocks that appear relatively inexpensive compared to their current profits. Growth companies are stocks that investors expect to grow profits rapidly in the future, so investors are often willing to pay a higher price for them today. Blend companies might share qualities of value and growth companies.

Put this all together and you can see that there are “large-cap growth” companies, “large-cap blend” companies, and “large-cap value” companies. The same goes for mid-cap and small-cap. In total, then, we can see that there are nine equity style boxes.

Putting this into practice, Vanguard’s S&P 500 index, VOO, currently holds 81% large-cap, 18% mid-cap, and 1% small-cap. While the fund is diversified across 500 companies, it is not well-diversified under the lens of the equity style box. The Invesco QQQ Trust, which tracks the Nasdaq 100 index, is even less diversified, with 89% of its holdings in large-cap and only 9% in value at the time of writing. While each of these funds is more diversified than a few single stocks, an investor can certainly diversify further and reduce risk without giving up expected returns.

While broad diversification does not require that all of the parts of the equity style box are represented equally, it makes sense to have investments in each area. Remember that the main point of diversification is to prevent your entire portfolio from suffering badly when a particular part of the market drops. A fund like the QQQ, while a high-quality fund, does not represent strong portfolio diversification. I would suggest that investors holding QQQ also hold other funds that represent mid-cap, small-cap, and value areas.

It is not unusual to see long periods of overperformance in one style box while other boxes lag. Nevertheless, historical evidence shows that most investors struggle to predict those future outcomes, which can negatively impact results. For a typical investor, a well-diversified portfolio will provide resilience and higher levels of predictability in your investment outcomes.

Use those equity style boxes as one tool to help you build your portfolio. Don’t forget to research other diversification areas as well, including the ones mentioned earlier (different countries, etc.)

However you choose to diversify your portfolio, invest smartly and invest well!

Larry Sidney is a Zephyr Cove-based Investment Advisor Representative. Information is found at https://palisadeinvestments.com/ or by calling 775-299-4600 x702. This is not a solicitation to buy or sell securities. Clients may hold positions mentioned in this article. Past Performance does not guarantee future results. Consult your financial advisor before purchasing any security.