Find the Route to Real Diversification

Physician's Money Digest, April15 2005, Volume 12, Issue 7



Modern portfolio theory illustratesthat 90% of a portfolio'sreturn is generated by assetallocation rather than through stock selection.Armed with this information, youmay be tempted to build your portfolioon the foundation that the most productivestocks are going to come from thebest industries and sectors. On the otherhand, you may be tempted to dispensewith stocks altogether and invest inExchange Traded Funds (ETFs), which arebaskets of stocks that trade like individualstocks. Investors like ETFs because many ofthem are organized into industrial sectorsto allow for asset allocation by sector. Asset allocation doesn't necessarilywork within an equity portfolio.

Sector Allocation

The S&P 500 consists of 10 sectors thatare made up of 245 industries. Each companyis assigned an industry based on itsbusiness components, and each industryfalls into a specific sector category. At anygiven time, a sector or industry can standout based on economic considerations,geopolitical events, risk/reward aspects,public perception, earnings expectations,or a host of other variables. Sortingthrough this list of potentially rewardingor deteriorating characteristics can provequite daunting for many investors.

These are some reasons why modernportfolio theory is essentially the philosophicalopposite of stock picking. Onereason is because it is the creation ofeconomists. Economists try to understandthe market as a whole, whereasbusiness analysts look for what makeseach investment opportunity unique.Although it's true that strength withinan industry can boost a stock's price performance—the rising tide raises all boatstheory applies to the stock market aswell—the fact remains that markets areharsh on stocks whose prices are foundto be fundamentally unwarranted.

Smart Investing

As with any asset allocation decision,the size of your portfolio's core equityholding should reflect your investmentgoals, time horizon, and risk tolerance.However, once you make the decision toinvest your core in equities, you should beprepared to move forward with a logicalinvestment strategy that helps youachieve your goals.

With this in mind, consider that studiesshow that investors are typically emotionallydriven and that this results in aherd mentality. Therefore, the marketrises and falls, to a large degree, basedon investor psychology. In addition, systematicpatterns have been shown toachieve better results in the market. Thisevidence backs up the idea that a disciplinedapproach to investing is the key tooutperformance in the stock market.

Finally, history suggests that within aspecific sector, one stock may do wellwhile a corresponding stock underperforms.Therefore, exposure to growth andvalue stocks as well as small, mid, andlarge cap companies may provide an additionallayer of diversification. With thisidea in mind, consider a core investmentstrategy. This strategy embraces all styles,seeking the specific fundamental characteristicsthat make a company profitablerather than attempting to find companiesthat fit into a prescribed box.

is the president and

founder of Red Mountain Research

Company, an Internetbased

firm. She has been a money

manager for large and small firms

in the United States and abroad for

20 years. Ms. Helm created Red Mountain to offer

frank equity management advice to the public. She

welcomes questions or comments at, or for more information


Colleen Helm