Although Ian Wyatt called himself a devoted small-cap investor, his portfolio contains more than simply small caps.
“Small caps are my favorite among equity choices for reasons I have explained in this book. While I continue to hold to this belief, I do not put all of my eggs in one basket, since the risk would be overwhelming. It makes much more sense to diversify on several levels: by company and sector, company size, and investment type.”
From his perspective, in chapter eight of “The Small-Cap Investor: Secrets to Winning Big With Small-Cap Stocks,” small-cap stocks should be part of a broader portfolio, rather than the core around which a portfolio is built. He added that the proportion of small caps should be determined by risk tolerance — the greater the risk an investor is willing to take, the greater the proportion of small caps.
Within the equity portion of a portfolio, these types of diversification are available:
- Company-based: Holding more than a few companies at a time to avoid losses that are company-specific rather than market-wide.
- Sectoral: For example, the crash of 2000 affected mostly technology and internet stocks. Other sectors were less affected.
- Economic/market/political: For example, sectors such as defense can be deeply affected by political changes.
- Mixing in mutual funds or exchange-traded funds: A mutual fund, by definition, will be diversified in one way or another, and provide quick and easy diversification.
- Attributes and locations: Companies with different management styles or different geographic bases.
- Capitalization: Small-caps, large-caps and so forth.
Also, be aware of potential diversification mistakes:
- Not managing, that is, not responding to changes. The portfolio mix automatically changes each time a stock price rises or falls. Similarly, if you sell a stock, the balance changes unless the replacement comes from the same space.
- Beware the greed factor, when hot stocks tempt you to increase that allocation. As many of us recall, that happened with tech stocks in the late 1990s and housing and financial stocks in the mid-2000s.
- No risk awareness, even though it always exists. This is important to remember in bullish markets, including the one currently in progress.
- Ineffective levels of diversification, which refers to doing too little or too much. Wyatt wrote, “True diversification is defined as investing money so that no one factor affects your entire portfolio in the same way. If this is not a feature of your portfolio, then you have not yet achieved diversification.”
Following up on the latter risk, Wyatt devoted a short section to the dangers of overdiversification. Buying too many of any one type of security — whether equity, fixed income or real estate — an investor ends up with near-equivalent of an index fund, but at a much higher cost, thus nearly guaranteeing a suboptimal return.
More on the use of mutual funds and ETFs
While it is easy to say mutual funds provide diversification, picking a specific fund or ETF is less easy. Wyatt made these recommendations:
- Management: Has the management team earned its fees by outperforming the market over several years?
- Stated objectives: Based on your personal objectives, choose growth, income, large-cap and so forth.
- Fund portfolio size: Smaller funds, like smaller-caps, are more likely to produce capital appreciation than larger funds and especially mega funds.
- Types of investments: Again, based on personal objectives, choose the appropriate type, whether growth, income or anything in between.
- Fees and charges: Start by avoiding front-end or back-end commissions. Wyatt also recommends the use of fund cost calculators, many of which can be found online. For more on the importance of mutual fund costs, see this article.
ETFs are a variation on mutual funds. They are often based on indexes, allowing them to incur minimal fees and charges and making them passive rather than active investments.
Risk tolerance and diversification
Wyatt wrote, “Diversification by risk tolerance is a surprising idea to many people. But think for a moment about what risk really means. It is the exposure to danger in some form. So in the market, are you content to having all of your capital exposed to the same market risk?”
Therefore, he recommends diversification based on assumptions about risk. For example, “You would find it unacceptable to invest all of your money in gold, so by the same argument, why are you willing to invest all of your money in stocks?”
The basics of asset allocation
Asset allocation refers to the practice of dividing an overall investment portfolio into different types of securities, such as equities (stocks), fixed income (bonds, Treasuries), cash and real estate. Note that each of these investment classes “can operate independently of one another.”
Wyatt emphasized three points about asset allocation:
- Apply the concept individually and not universally. There is no reason any individual investor should accept a formula such as 50% equities, 40% fixed income, 5% real estate and 5% cash. Investors should create a formula that reflects their risk considerations.
- Include real estate in the asset allocation mix. This might include your own home or the purchase of real estate investment trusts or real estate ETFs.
- While stocks may be classified as one asset class, it makes more sense to think in terms of subclasses. This would include market capitalization or other distinctions.
In summary, Wyatt explained the importance of diversification in chapter eight of “The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks.” He also explained how an investor might diversify to reduce risk, while also pointing out potential mistakes.
(This article is one in a series of chapter-by-chapter digests. To read more and see digests of other important investing books, go to this page.)
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