Building a diversified portfolio means investing in a mix of large, stable corporations and smaller companies with growth potential. Here's what you need to understand about market capitalization and how it should inform your asset allocation strategy.
are shouting at us to buy and sell specific stocks on a daily basis if we want to get rich fast.
But is this the right approach? And is it even realistic?
Stock picking can be rewarding, but it’s a dangerous game if you don’t know what you’re doing. It’s also risky if you’re not investing enough money to be well-diversified.
As a new investor, you’re going to be better off investing in a broad mix of stocks and bonds. You can easily do this by putting your money into ETFs and mutual funds.
But where you do start? How do you know which investments are right for you? And what about asset allocation?
In this post I’ll break down the most common types of ETFs and mutual funds. I’ll also explain market capitalization and its importance to your investment strategy.
Finally, I’ll cover asset allocation and show you how to quickly build a diversified portfolio. Let’s first start by understanding market capitalization (also known as market cap).
What’s Ahead:
What is market cap(italization)?
Before understanding the different types of mutual funds and ETFs, you need to understand market cap. Market capitalization is a quick way of determining how large a company is.
To calculate market cap, take the share price and multiply it by the number of shares outstanding (meaning shares that anyone can buy). This will give you a dollar amount, which is the company’s market cap.
Here are the most common names you’ll see, as well as their corresponding market caps:
- Large cap – $10-$100 billion
- Mid cap – $2-$10 billion
- Small cap – $250 million-$2 billion
For example, let’s say Company A has a stock price of $10 and has 1 million shares outstanding. Their market cap would be:
$10 x 100,000,000 shares = $1,000,000,000
So Company A has a market cap of $1 billion. According to the list above, this would make them a small-cap company.
Mutual funds and ETFs will often categorize themselves by the size of companies that they invest in. For example, a large-cap ETF will hold stock in only large-cap companies.
There are a few other types of market caps you may see, but not as often. They are: mega cap (> $100 billion), micro cap (< $250 million), and nano cap (usually <$50 million).
Further reading: Growth vs. Value Funds(Fidelity). Many funds will have “growth” or “value” in their name. This article will break these down so you can further educate yourself on choosing the right investment.
Why you should consider smaller companies for your investing strategy
Investing in small-cap companies is an important element ofyour investment strategy. Smaller companies tend to have a greater chance of large growth, faster.
For instance, a company with a market cap of $500 million is more likely to double in value than a company with a market cap of $500 billion.
Smaller companies also don’t have as much analyst coverage as large companies. This leaves room for smaller companies to go unnoticed. If you’re putting time into research, you can find smaller companies that are very profitable.
Lastly, small cap companies have theability to outperform large cap companies. This doesn’t come without risk, though.
There are some factors to consider before investing in smaller companies. Smaller companies are more volatile.
While you may get a larger return on your investment, you also open yourself up to more risk. Many smaller companies have not been around as long and may not last.
This is the beauty of small-cap ETFs and mutual funds. You don’t have to pick individual small companies to invest in. You immediately diversify yourself and invest in a basket of smaller companies.
So while investing in a small-cap ETF or mutual fund can be riskier than investing in a large-cap fund, it’s a necessary element ina diversified portfolio. Remember, rewards don’t come without risks in investing.
Ideal asset allocation (and how to choose)
One thing to consider is your own personal level of risk tolerance. Everyone’s asset allocation for stocks is going to be different based on the level of risk that they’re willing to take on.
The first thing to consider is your allocation between stocks and bonds. As a younger investor, you have the ability to take on more risk. This is because the timeline before retirement is much further out for you than somebody who is closer to retirement age.
Because of this, I recommend no more than 10% of your portfolio in bonds. The other 90% should be broken up into four fund classes: large cap, mid cap, small cap, and international.
The percentage allocation that I recommend is:
- 30% large cap
- 20% mid cap
- 20% small cap
- 20% international
- 10% bonds
This will give you a well-balanced and diversified portfolio and allow you to tap into foreign markets and have some bond stability.
There are also some services that will choose an asset allocation for you. This can be good if you’re unfamiliar with investing or don’t want to put the time into figuring out what’s right for you. The downside is that you lose the ability to choose a specific allocation of investments that fit your strategy.
Popular robo-advisors that can help you to create a balanced portfolio includeBettermentandWealthfront.For example, Wealthfront creates tailor-made diversified portfolios in just a few minutes. If you’d prefer a hands-on approach, you can also create a portfolio from scratch or customize a recommended portfolio. Wealthfront even includes automatic rebalancing and dividend reinvestment, and there’s no manual trading required.
Investments to get you started
Here are some well-known ETFs and mutual funds to look into as a starting point for your investment strategy:
Large cap
- ETF: Vanguard Growth ETF (VUG)
- Mutual Fund: TIAA-CREF Large Cap Growth Fund (TILGX)
Mid cap
- ETF: iShares Morningstar Mid-Cap Growth (JKH)
- Mutual fund: T. Rowe Price Institutional Mid Cap Equity Growth Fund (PMEGX)
Small cap
- ETF: SPDR S&P 600 Small Cap Growth ETF (SLYG)
International
- ETF: iShares MSCI EAFE Growth (EFG)
- Mutualfund: Fidelity Series International Growth (FIGSX)
Bonds
- ETF: iShares Core U.S. Aggregate Bond (AGG)
- Mutual fund: Fidelity Total Bond (FTBFX)
Conclusion
It’s important to know the difference between ETFs and mutual funds, as well as their strategies, before investing. Also, understanding market capitalization is crucial before choosing your own investment strategy.
You also want to make sure you’re comfortable with your asset allocation so you’re not too heavily weighted in one asset class. This will help you keep a well-balanced and diversified portfolio.
Next steps
Ready to build a diverse portfolio?Here are some tools that can help make it easy:
- Betterment SmartDeposit: A new way to automate your investing
- Personal Capital: A powerful free app for analyzing your portfolio
- Wealthfront: Online investment management
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