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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75383  
Subject: Re: Questions on diversification and MPT Date: 6/1/2011 12:45 AM
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First thought - lets start with the basic building block of asset classes. There are 4 or 5 based on the broad definitions.

Cash/Cash Equivalent,
Equity/Stocks,
Debt/Bonds,
Real Estate,
Commodities.

Some put RE and commodities in the same bucket and some pull precious metals out of commoditites (but leave base metals in - go figure) But, this is the universe. There are hybrids but basically this is it.

Lets look at this with a little biological taxonomy - Class as mentioned above. Then we have Order, for that I would suggest Domestic Market, Developed Market, Growth Market, and Emerging Market. To keep along this line.

Class = Asset Class above
Order = Market
Family = Sector
Genus = Style Box (cap and value)
Species = Company

At each level there are different characteristics to consider.

Lets start with everything in Equities:

rainphakir makes the point, where do you want to be and where are you now helps with determining the class. Along the lines of risk tolerance, if you know you already have what you need, then you are in preservation mode.. Probably lean more toward Debt and Cash & CE (cash equivalent) I am not a fan of the age in bonds or anything related, that is more of a risk based decision. Age may play into risk but the risk may be vastly different based on balance sheet and income.

If you are in the median range you want to be in the markets and add some risk then you are in the invested category.

You are in the early years of investing and have a light balance sheet so you probably have more risk tolerance which will then lean toward Commodities and Real Estate and being lets call it aggressive. So pulling some numbers out of the hat.

Preserve Invested Aggressive
Cash 25% 10% 0%
Bonds 60% 15% 5%
Equities 15% 50% 60%
RE 10% 15% 20%
Commodities 0% 10% 15%


Now any one of these number can change based on vies you have. IF you are in preservation and believe gold is better than sliced bread, take some out of bonds or equities and put it there. IF you like RE well, a little extra from something you dont like. Or, perhaps you beleive that dividend equities (T, P&G, SO) are just as good as bonds, well you get the idea..

That is perhaps a way you can look at the asset classes.. the pie split up because of risk return characteristics

Then start to think about "diversification" Do you put it all in the US, or tim's mother land (Can a something!) Broadly the overall markets are fairly correlated but plot out some ETF's and get a sense for yourself. This is not just the equities. Debt crosses border, RE, and commodities can be targeted toward different markets. Or Currency!!

So if aggreesive
60% Equity, 35% US, 15% Developed, 5% Growth, 5% Emerging
20% RE, 15% US, 5% Developed, a pinch?? over here
15% Comm. 10% US, 5% Developed,

Next in the steps adds a little more diversification, Family = Sector! But lets face it, if technology stocks are suffering in the US, they are probably suffering in the developed markets. There are a couple of ways to divy up the sectors, and depending on risks you can go from Utilities to Technology. I think this is a bigger building block of diversification than the style box which is next.

35% US, ~4% in nine sectors or underweight ones you dont like and overweight ones you do..

Once you have the sectors mapped out, think about Genus = Style, if you are a value investor (large cap Value) or if you subscribe to Hidden Gems (small cap growth) and how much you want to put in this. The last two may go hand in hand Style and Company (species)

4% in consumer discretionary and you are large value - Which brings us to the final level - the species, the company and here is where the diversification takes place. By the time you have got down here you are putting diversification in the forefront..

Consumer discretionary think about YUM and McDonalds.. Seems like the same, but think about, American Eagle Outfitters, Disney and McDonalds.. all "discretionary" but a little different.

Beauty is you can stop drilling down whenever you want.

ETF for total market, or
ETF for US, Foreign, Emerging
ETF for Sectors
ETF for Style

This post is already long enough - but perhaps something to consider!

d(5 asset classes)/dT











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