This is part of a series of posts for an online class on how to use your investments to fund your retirement. To find other posts in the series, select the category “Retirement Investment Class” under “Retirement Investing” at the top. The posts will appear in reverse order, with the newest post first.
In the last post in this series, How to Evaluate Mutual Funds and ETFs, we briefly talked about the Style Box. Today we’re going to go into a lot more depth on how to use this useful little tool for evaluating mutual funds and the concepts behind it. This is one of the most important topics for determining how to determine your asset allocation. Get this right and you’ll gain a couple of percentage points of return each year, which will translate into millions of dollars in a retirement account held over four decades or more. It is still important in retirement investing as well, although how you allocate your money will be somewhat different.
Today we’ll discuss the style box typically used for stock mutual funds. Bond funds use one as well, although the categories would be different. A sample stock fund style box, taken from the description of one of Schwab’s mutual funds, is shown below. On the bottom, horizontal axis, the investment style is shown, going from Value to Growth investing. In the middle is Blend, which just means it is a combination of both Value and Growth investing. On the vertical axis is the market cap, including small, mid, and large cap. We’ll go over each of these categories.
There are two main styles of investing, both of which have been applied successfully and both of which work well at different times. The first is value investing, which is based on what is known as the Firm Foundation Theory. The Firm Foundation Theory says that a stock has an appropriate price, or value, based upon the fundamentals of the company. Stocks that have a price exceedingly below this value are considered inexpensive and likely to increase in price, while those that are priced way above this value are considered high in price and likely to decline back to the appropriate value.
People who are value investors would look at earnings, property, and the prospects for future earnings and determine a value for the company. They might, for example, look at the price/earnings ratio, or PE, which is the price of the stock divided by earnings per share. They would compare the PE value to both the historic range of values for the company and to the PE ratios of other companies in the same line of business. They would seek to buy stocks that have a low PE, meaning that they are cheap compared to their value, and sell stocks they hold that have a high PE, meaning that they are expensive compared to their value.
Growth Investing involves finding stocks in companies that are growing rapidly and buying their shares. This often involves finding the stocks that are reaching all-time highs and buying their shares, relying on the momentum of the company’s share price to continue. Growth investors would look at things like earnings and dividend growth rate, the number of new stores that are being opened or the potential size of new business lines a company is creating. They would tend to buy smaller companies that have potential to grow, shying away from companies like WalMart and McDonald’s that have already expanded greatly and would have difficulty doubling their earnings.
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Often value investors are buying stocks in companies that are having financial issues, which makes value investing slightly more risky than growth investing since some of the companies they’ll buy will not be able to turn things around and go bankrupt. Growth investing also has a risk, however, since sometimes companies grow too fast, taking on debt while they do so, and end up needing to sell off assets and restructure. Growth investors are also buying shares of stock when they have already gone up in price, hoping that they will continue to go up, so they sometimes overpay for them. Over the history of the US markets, value investing has outperformed growth investing on average but not always. An exception is the period from 1980 through 2000, during which time growth was king. Growth also outperformed value from 2008 through 2016, although value has done better during this last year.
Market cap, or market capitalization, is how large a company is. Market cap is found by multiplying a stock’s price per share by the number of shares outstanding. Small cap companies obviously have small market values, while large caps are huge enterprises like Home Depot and Google. Small caps have more room to grow, given their small size, which means that they have a lot of growth opportunities, but large caps have the ability to get better pricing through concessions from vendors, as well as the ability to weather downturns by expanding into multiple business lines and/or parts of the world. Mid caps fall between the nimble small companies and the Fortune 500 companies, but should be thought of as an extension of small caps since they tend to perform similarly.
Over long periods of time, small caps will outperform large caps since they have more room to grow. The exception is turn-around companies that shed a lot of the old baggage and in a sense become new companies again. During any given 10-year period small caps may outperform large caps, or large caps may outperform small caps, so you can never really be sure about which asset class would make the better investment. If I were buying and holding for a 40-year period and had to choose one, I would buy small caps since they would grow more than large caps and outperform. If I were holding for a 10-year period, however, I would probably choose large caps since they would likely hold up better should a business downturn occur since they have more cash reserves and financial stability.
Setting up a Portfolio
Now that we’ve discussed the style box and the different investing styles and market capitalizations, how does an investor put this to use? In setting up a portfolio, you’ll want to cover the full spectrum of investing styles and company sizes. You don’t know which style and company size will perform best during any given period, so you want to invest in everything to make sure you are in the sector that is doing the best at any given time. This means that you’ll never have all of your money in the sector that does the best and make the maximum possible returns, but it also means that you’ll never be entirely in the sector that is doing the worst and miss out on a good rally or bear the brunt of a big decline. There is no way to know which sector will do the best over the next year or ten years, and attempting to guess will normally cause you to underperform the overall markets, so it is better to accept that some portions of your portfolio will always do worse than others in exchange for always having at least some of your money in the hot sector at any given time. Just realize that those that lag now will probably lead in the future.
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So, you’ll want to buy funds that either cover the four corners of the style box or buy both small cap and large cap blended funds that include both growth stocks and value stocks. You can also buy mid-cap stocks to further diversify your holdings. You can also cover everything by buying a total market fund, which basically invests in everything, all in one fund.
If you are young, because value will outperform growth over long periods, and small caps will outperform large caps over equally long periods, you may want to skew your holdings slightly into these areas if you have decades to wait. In doing so you’ll probably slightly outperform an evenly split portfolio, but not by much. This becomes more important the longer the time period over which you are investing since small differences only add up to big money over long periods of time. For those already in retirement, however, it is better to either split things evenly or even skew more to the large cap side due to their larger dividends and stability. In the next post we’ll provide model portfolios based on these ideas and show how this is done.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.