Educational Programming Video

The Value Line Mutual Fund Survey
Program 17: Financial Planning Part 6

In the last several sessions, we discussed individuals' investment profiles. We'll continue the discussion in this lesson, touching on some of the different types of asset classes available to investors.

By way of background, asset allocation, which we simplistically defined as diversification of financial investments among stocks, bonds, and cash, and more specifically as trying to squeeze the greatest potential return out of a given level of risk, is the tool by which investors reach their goals.

Although Diversification automatically dilutes the potential return, some assets typically rise when others fall and others usually fall less sharply than the average. This fact makes it possible to diversify among asset classes in such a way as to lower the potential risk by a greater amount than one lowers the potential return.

Although there are differing opinions about what the proper asset allocation among stocks, bonds, and cash is, the place to start is to understand the different asset classes and their subcategories, and how these categories interact.

The first breakdown is the broadest—stocks, bonds, and cash. Stocks, or equities, represent an ownership share in a corporation, such as IBM. Bonds, meanwhile, are long-term debt obligations. Those who invest in bonds generally receive monthly or quarterly interest payments, plus the return of their principle when the bond reaches maturity. Cash, the simplest of the asset groups, is comprised of very liquid, short-term savings tools, such as a bank account or certificates of deposit, or CDs. Money market accounts also fall under the cash category.

In general, stocks are the most volatile and diverse of these three broad categories. Indeed, Value Line breaks stock mutual funds into 21 broad groups and over 10 more sub-groupings. These categories allow us to classify funds from Aggressive Growth funds with a large-cap bent to Utilities funds that invest globally. This fine-tuning is important because it allows investors to pick the funds that are most appropriate for their portfolios based on their risk profiles.

What does that really mean? As we've discussed, the stock category encompasses a broad array of companies, from volatile high-tech names to more reliable real estate companies. Each of these sub-groupings acts differently.

Value Line recommends that investors look for mutual funds that fall into seven broad equity categories: Large-Cap Growth, Large-Cap Value, Small-Cap Growth, Small-Cap Value, Foreign Stock, Emerging Market, and Gold & Resources.

Let's review each of these categories.

Large-Cap Growth funds invest primarily in large companies (generally those with market capitalization exceeding $10 billion), with a focus on companies that have rapidly growing earnings.

Large-Cap Value funds invest primarily in large companies with a focus on stocks that may be undervalued relative to the market. Value is usually defined as low stock price to earnings ratios and/or low stock price to book value rations. It is expected that the market will realize the miss-pricing of these issues, and their stock prices will rise.

Small-Cap Growth funds buy primarily smaller companies (generally those with market capitalization not exceeding $2 billion or so), with a focus on growth stocks.

Small-Cap Value funds invest primarily in small companies with a focus on value stocks.

Foreign Equity funds invest the majority of their assets in common stocks of non-U.S. companies.

Emerging Markets funds, meanwhile, invest the bulk of their assets in common stocks of companies located in countries with developing economies (as opposed to those with more-stable or mature economies, such as Japan or most European countries).

Gold & Natural Resources funds fall into two groups, Precious Metals funds and Energy/Natural Resources funds. Precious Metals funds have a stated policy to invest at least 50% of assets in companies involved in the gold and/or precious-metals arena, including silver, palladium, platinum, and diamond companies. Energy/Natural Resources funds invest in the common stocks of energy companies, such as oil firms like Exxon/Mobil, and natural-resources companies, such as paper companies.

Value Line recommends the use of these asset groups because they tend to perform in different ways in different market conditions. Growth oriented funds perform well in strong markets, such as the one seen in the late 1990s. Value Funds, on the other hand, often do well in a slow growth economy, as investors look for "safe havens." Also, large-cap and small-cap funds often perform well at different times. Foreign funds have historically aided overall portfolio performance because they do not track closely with the U.S. markets—meaning that they often rise when the U.S. market falls, and vise versa. Although there is some evidence that foreign markets are starting to behave more similarly to U.S. markets, foreign funds still offer U.S. investors a vital degree of diversification. Emerging markets funds do not tend to track well against any other type of fund because of their highly volatile nature. These funds are investing in countries with a lot of specific risk, and, as such, tend to move independently from other asset groups. Gold and Natural Resource funds, the last of the recommended groupings, tend to perform well in down markets as investors fears of doom and gloom lead them to invest in "hard assets" that have intrinsic value, such as a bar of gold.

In the next session, we'll take a closer look at some of the different funds that might fall under each of these broad groups to help you get a better handle on the stock category.