The importance of proper diversification is a cornerstone of SMI's investing philosophy. We frequently stress the critical nature of the stock/bond allocation decision, that is, how you divide your assets between investments where you are an owner (such as stocks) and those where you are a lender (such as CDs and bonds).

Beyond that, however, there is also the decision as to how to diversify your stock holdings among various "sub-groups" of stocks and bonds. In this article, we'll be focusing on the stock portion of that decision.

The first distinction within the stock category is between foreign companies (SMI's Risk Category 5) and those in the U.S. (Risk Categories 1-4).

Within the U.S. stock group, two major divides exist: large vs. small companies, and value vs. growth investing philosophies.

  • Large vs. Small.
    Company size is easy to understand — simply add up what it would cost to purchase all the available stock of a given company. Larger companies that would cost billions (sometimes hundreds of billions) to purchase are placed in Risk Categories 1 and 2. Smaller companies, whose market value can typically be measured in hundreds of millions rather than billions of dollars, wind up in Risk Categories 3 and 4.
     
  • Value vs. Growth.
    The difference in investing philosophies (i.e., management styles) can be roughly thought of this way. Value investors tend to be bargain hunters (Risk Categories 1 and 3). Growth investors seek those companies with the best future business prospects and are usually willing to pay a higher price (Risk Categories 2 and 4).

Is either of these sizes or styles inherently better than the other? No. Both large and small companies have tended to produce similar returns over extended periods of time. So have value and growth management styles.

However, the path each group takes tends to be quite different. As the charts below illustrate, the various size and style groups move in and out of favor with investors, meaning it's not uncommon for one group to be highly sought after while the other is relatively ignored, sometimes for years at a time.

The chart below shows how investors favored large-company stocks to such a degree in the late 1990s that small-company shares became significantly under-valued relative to those of large companies. This trend reversed over the next dozen years, with small-company stocks recently being favored so strongly that you'd have to go all the way back to 1982 to find the last time small-company stocks were valued so richly relative to large.


(Click chart to enlarge)

 

The growth/value trends were equally dramatic around the turn of the century, with growth stocks strongly in favor toward the end of the tech bubble and value stocks rebounding sharply over the following several years. Growth had another small run at the end of the last decade, but the two styles have been roughly even since 2010.

What do these charts tell us about the future? Well, in the case of small vs. large, they tell us it's reasonable to expect that large-company stocks are likely to come back into favor. Given the tendency for large-company stocks to outperform in the latter stages of bull markets, the timing of that shift would seem to be sooner rather than later. These were primary factors in SMI overweighting our large-company allocations in 2013 and 2014. (See Preparing for Greater Bond Risks In 2014.)

These trends tend to act like rubber bands: they stretch — sometimes farther than expected — but eventually, they snap back. This is called "reversion to the mean" (i.e., the long-term average). While recognizing these trends can be helpful, SMI believes that owning a mix of all four stock types is normally the best approach.

The timing of these trend shifts is unpredictable and it's usually not wise to try to predict when they are likely to reverse. Thankfully, these trends frequently persist long enough for us to still profit, even after waiting until a new trend is firmly established before shifting our allocations to take advantage.