by Michael Tate, CPA

Diversification:

Spreading of risk by putting assets in several categories of investments; stocks, bonds, money market instruments, and precious metals, for instance, or several industries, or a mutual fund, with its broad range of stocks in one portfolio.

The following is a simplified example illustrating how diversification can work within an investment portfolio:

Consider two portfolios. Portfolio A has three stocks purchased in equal proportions. Portfolio B has 100 equally-weighted stocks. The expected return of the securities in each portfolio is 10%. One of the stocks in each portfolio is Gold Rush, Inc. It is determined that Gold Rush, Inc.'s claim to have located the largest vein of gold in world history was entirely fictitious: there is no gold in any of Gold Rush's mines. The price of Gold Rush, Inc. shares falls precipitously and the company is ultimately bankrupt. Portfolio A's value would decline by 33% as a result of the collapse of Gold Rush, Inc. To compensate for the decline in Gold Rush, Inc. shares, the portfolio's other two stocks would have to outperform expectations considerably. In contrast, Portfolio B's value would decline by only 1%. In this case, the 99 other stocks in the portfolio would have to outperform only marginally to compensate for the loss due to Gold Rush, Inc.

With a stronger comprehension of diversification, this knowledge needs to be correlated with the understanding of asset classes, which we use at Tate, Propp, Beggs and Sugimoto in creating a diversified portfolio.   

An asset classes is a broad group of individual securities with similar characteristics (e.g., risk, capitalization, and dependence on particular economic factors). The groupings may be broadly defined such as stocks, bonds, cash, and real estate, or more narrowly defined, such as small-capitalization growth stocks. 

To be classified as an asset class, a group of securities must:

• respond to economic and market effects in a similar way
• perform in a way that is distinguishable from other groups of securities
• be investable

Within the discussion of asset classes the term Book to Market (BTM) needs to be understood.  The calculation compares the book value of a company – the net asset value of a company which is taking all their assets less their liabilities – to their market value – total share outstanding times their stock price. 

For example  Company A’s book value is $1,000 and their market value is $5,000, their book to market calculation is .20.  Most companies trade at a multiple of what the book value of their assets is.

This calculation can be used in comparing the various asset classes offered through Dimensional Fund Advisors (DFA) which comprise a large majority of our portfolios:

DFA US Large Company Portfolio

              Weighted Average Market Cap              90,917M

              Weighted Average Book to Market        .37

DFA US Large Cap Value Portfolio1

              Weighted Average Market Cap              21,632M

              Weighted Average Book to Market        .82

In comparing the above two asset classes, you will note that one is defined as value and one is not.  The DFA US Large Company Portfolio has a Book to Market (BTM) of .37 vs. the DFA US Large Cap Value Portfolio has a BTM of .82. 

What does this tell us?  The Value portfolio is trading at a price which is representative of the book value of the underlying assets.  Using our example from before, if the net assets are $1,000, the company is trading at a market value of approximately $1,220.  There is not much of a multiple on the company’s assets.  The US Large company would be trading at a market value of approximately 2,700, a much higher multiple.  This should indicate to us that the market is more excited about the US Large company stocks and have bid up their price well above their underlying assets.  The market likes these companies.  They are big names such as Wal-Mart, Microsoft, etc.  As for the value portfolio, the book to market calculation is telling an investor that the market is not too excited about those stocks and in turn has not bid up their prices significantly above their underlying assets.  Possibly their products are not as popular, management has run through a bad spell, etc.  Example of this might be K-Mart. 

When an individual is asked if they would rather invest in Wal-Mart or K-Mart, 99% of the time the individual will say Wal-Mart.  This is due to the market and their perception that Wal-Mart has great management, lots of stores, and a well known company which delivers a high quality product.  If you asked me, I might say K-Mart.  Yes management has had some problems, their brand name has gone through changes, and other factors which are reflected in their low stock price.  But I am banking that they will turn it around.  I am going to buy while the price is low and as management turns the company around, I will ride the stock up as the market recognizes their improvement.  Their BTM will decrease and I will enjoy those profits.  The key is owning a very large number of value companies to diversify the risk of an individual company going bankrupt.  For example, the DFA Small Cap Value Portfolio had 1,411 different company holdings as of June 30, 2004.

The understanding of asset classes needs to be taken a step further from book to market with the comparison of large vs. small capitalization (cap) stocks.  This is an important aspect to understand because size of companies can produce differences in their investment behavior.  For example, consider a large food-products conglomerate versus a tiny specialty-coffee maker. Both companies produce nondurable products, but the conglomerate has a diversified product line, is well-established, has deep market penetration, and stable earnings. On the other hand, the specialty-coffee maker is tiny, untested, and has been in existence for a fairly short time. The two companies are likely to perform very differently--with the expectation that the smaller company is likely to be riskier than the larger company. A meaningful sub-categorization of domestic stocks is large versus small companies.

DFA US Small Cap Value Portfolio1

              Weighted Average Market Cap              747M

              Weighted Average Book to Market        .79

DFA US Micro Cap Portfolio1

              Weighted Average Market Cap              392M

              Weighted Average Book to Market        .50

International Markets

In looking at foreign stocks, a reasonable sub-categorization is in comparing developed countries to emerging markets. In other words, it is fair to say that the stock for a Brazilian company will tend to perform differently than the stock for a German company. Developed markets such as Germany are easily investable and have a greater degree of political and economic stability than countries in South America. Emerging markets, such as Brazil, have a lesser degree of market development, thereby introducing such issues as transfer risks, property rights, settlement risks, liquidity risk, informational risks, and shareholder treatment. As a result, investing in emerging markets generally involves greater risk than investing in developed markets.

DFA International Small Company Portfolio1

              Weighted Average Market Cap              705M

              Weighted Average Book to Market        .67

DFA International Small Cap Value Portfolio1

              Weighted Average Market Cap              606M

              Weighted Average Book to Market        1.02

Some of the countries invested in include Australia, Austria, Belgium, Germany, Greece Italy, New Zealand, Sweden, and the UK

DFA Emerging Markets Portfolio1

              Weighted Average Market Cap              6,836M

              Weighted Average Book to Market        .54

DFA Emerging Markets Value Portfolio1

              Weighted Average Market Cap              1,647M

              Weighted Average Book to Market        1.03

Some of the countries invested in include Argentina, Brazil, Chile, Israel, Mexico, South Korea, and Turkey

Conclusion

Asset allocation is predicated on being able to evaluate the general trends of performance of groups of securities under various economic and market conditions.

If one wishes to combine asset classes within a portfolio, they must be able to clearly define how they are likely to perform, based on past experience. This is only possible to do if the returns of securities within the asset class bear some relationship to one another. Asset allocation is also predicated on the ability to locate unique asset classes whose return patterns are different from one another. Therefore, securities can constitute separate asset classes only if they respond differently to economic and market events.

For additional information on this topic and/or other questions regarding the investment advisory services offered through Tate, Propp, Beggs & Sugimoto, please contact Michael Tate by email.

Dimensional Fund Advisors Equity Characteristics as of June 30, 2004.