Understanding asset classes for better portfolio diversification

Size

One way to increase the diversification of your investments in companies is to make sure you’re investing in companies of different sizes. Companies are usually broken down into three categories by size, and their size is determined by their market capitalization, or market cap for short. (That’s the technical term for the value of the company.)

• A small cap stock generally has a market capitalization of under $2 billion.
• A medium cap stock generally has a market capitalization between $2 billion and
• $10 billion.
• A large cap stock generally has a market capitalization over $10 billion.

Investing in all three can help diversify your portfolio because they can each experience different risk and return patterns.

Country

There are two major types of equity investments you can make when it comes to the region you’re investing in: domestic and international.

If you’re building a portfolio of ETFs, which give you access and exposure to hundreds of investments with a single fund, you’ll also see a third category based on country: global. A global ETF is one that contains stocks from both domestic and international companies.

When you’re diversifying between international and domestic investments, it’s important to understand that they do differ when it comes to their risk levels: International investments expose you to currency fluctuations, and some international investments are more volatile than others.

Style

There are two different investing styles you can diversify between when it comes to an ETF based portfolio: growth and value.

Growth investing aims to invest in companies that are poised to outgrow the general market, whereas value investing aims to invest in companies whose stocks are relatively cheap based on an analysis of the company and the market it operates in.

You can find ETFs that are built to track indexes that are built on each investment style, which is a great way to expose your investments to each style without having to do all of the analysis yourself.
 

Issuer

Bonds are generally issued by two types of organizations — companies and governments.

When companies issue bonds, there’s no guarantee of return on your principal investment. Which means company-issued bonds are typically higher risk and come with a higher potential for return. You’re relying on the company’s ability to pay back your money in the future.

On the other hand, many (not all) government bonds are guaranteed to return the principal invested and can be backed by state, local, and national government. That means they’re generally lower risk, but they also tend to come with a lower rate of return.

Credit quality

When you’re investing in bonds issued by a company, each company is given a rating based on their creditworthiness — similar to your personal credit score, but for companies.

Investment-grade bonds are issued by companies with a solid credit rating, typically a BBB-rating or above. That means it’s more likely that the companies will pay their debts, which in the case of bonds, means paying back the principal and the interest on your investment.

High-yield bonds come with a higher risk of default, because they’re rated BB+ or below. However, because they’re riskier, they typically offer a higher rate of return to attract investors.

Maturity

Bonds are issued for different amounts of time, so you can diversify by the maturity date of the bond as well. When a bond matures, the issuer returns your principal—but remember that some bonds are riskier than others, so that’s not a guarantee, just a general rule.

• Short-term bonds generally mature within one to three years.
• Intermediate-term bonds generally mature between three to six years.
• Long-term bonds generally mature in six years or more.

When you’re thinking about your portfolio as a whole, consider that generally speaking the longer the term of the bond, the higher the risk relative to other bonds from the same issuer. They’re more sensitive to interest rate changes, and your money is tied up for a longer time.