One of your most important investment decision is how much of your portfolio is allocated to stock-type investments and how much to fixed income securities like bonds. Diversifying by shifting some money from stocks into bonds has the effect of lowering overall returns somewhat, but it also greatly reduces the volatility of your portfolio.

While this stock/bond allocation decision is the most important diversification issue, it is by no means the only one you must address. No, after deciding how much of your portfolio is appropriate to allocate to stocks in general, it is important to then take the next step and diversify between different types of stocks.

To assist in this process, Sound Mind Investing divides the U.S. stock market into four parts, or “risk categories”.  (A fifth stock risk category includes mutual funds that invest primarily in foreign companies.) In doing this, we make two distinctions. The first distinction is when we separate funds that invest primarily in large companies from those that invest in smaller companies. Larger companies are slower growing, but are usually safer during recessions. Smaller companies have greater growth potential, but it's accompanied by greater risk.

The second distinction we make is based on a fund's "style" or "discipline." This refers to what kind of stocks that particular fund normally likes to buy. Funds typically fall into one of two major groups. The "value" group emphasizes how much you are getting for your investment dollar, meaning the price paid for each stock is very important. The "growth" group focuses instead on the growth potential of a company. If it has great future prospects, a growth fund may buy its stock regardless of whether it trades at an expensive price.

 

When we put these two criteria — size and style — together, we arrive at our four risk categories. Funds investing in large/value-priced companies are placed in SMI risk category 1, and those focused on large/growth-priced companies go into category 2. Likewise, funds investing in small/value-priced companies comprise SMI risk category 3, and small/growth-priced funds makes up category 4.

The four risk categories can be thought of as rungs on a ladder. As with real ladders, it's safer near the bottom, and risk increases with each ascending rung. Therefore, you can expect risk to be lowest with the large/value funds of category 1, with risk gradually increasing as you move up into the large/growth, small/value, and small/growth categories respectively.

Charts A-D below help illustrate this point. They show the annual returns of the funds in each of these four categories as tracked by the research firm Morningstar over a recent 20 year period. Note that over this period, the average annual returns of all four types of funds have been quite similar. Yet despite having similar average returns, the charts illustrate the radically different paths each group followed.

 

A comparison of categories 1 and 4 really highlights this difference, as the "tortoise and hare" contrasts are quite vivid. The small/growth funds of category 4 bounce up and down dramatically, with noticeably higher highs and lower lows than the other categories. Meanwhile, category 1 chugged along with less frequent (and less severe) losses, but also lower gains in the good years. Looking at all four categories together, you can see the tendency for volatility to increase as you move up the risk ladder (left to right in the charts above).

As important as the overall behavior of each category is, it's also worth noting that the four categories move out of synch with each other. Look at the first (far left) bar in each of the charts. It shows how in 1984, large/value funds gained roughly 7%, a stark contrast to the losses of 4%, 11%, and 9% the other three categories suffered. The third from last bar (2001) tells a similar story, with small/value funds gaining 16% while the other categories lost 4%, 22%, and 9%. If you look closely, you'll find years where each of the four categories dominated, and others where each type lagged.