Having made the case for the attractiveness of equities, let us now discuss the various ways professional investors slice & dice the equities asset class.
Size: Based on the market capitalization (no. of shares outstanding * share price) of a company, its stock can be classfied as large cap, medium cap or small cap. See the links for the size threshold for the various market cap categories in US & India. As mentioned in a previous post, the long-term returns of US small cap stocks are approx. 2% higher than the large-cap stocks. However small-cap stocks don't outperform large-cap stocks at all intervals. Markets tend to go through alternate cycles of several years where one category outperforms the other. Large cap stocks are generally perceived to less risky & are more liquid but the underlying companies are slow growing due to their massive size. On the other hand small cap stocks are considered more risky & illiquid but offers higher potential for growth.
A sensible investor can generally divide his equity allocation among these capitalization categories based on the percentage of total market capitalization they represent (sample distribution: large -> 75%, mid -> 15% & small -> 10%) and modify it tactically (by 1 - 10% points) based on ones risk preferences & judgement about their relative attractiveness at a given point in time.
Geography: Based on the domicile of listed companies, equities can be classified as developed or developing (also known as emerging) market equities. The developed market equities can be further classified into US (or North America) & EAFE (Europe, Australasia & Far East) because the dynamics of these two regions differ considerably (in technical speak they are not perfectly correlated) and their overall size (market cap) is approximately the same, i.e. about $14 trillion. Offcourse there are funds available for practically any country (of investing significance) but for the sensible investor the granularity to the level of four regions is sufficient; US (+ Canada), Europe, Pacific (Japan, Australia, Hong Kong, Singapore) & Emerging Markets. As per conventional wisdom, international investing (especially of emerging variety) is perceived to be more risky but also more rewarding because of better growth prospects.
Most asset allocation models I have come across prescribe a max. of 15-25% for EAFE & 5-15% for Emerging markets. While these recommendations makes sense in light of higher correlation among equity markets, inferior rights of the foreign investors in the unforseen event of a conflict between countries, poor corporate governance & the fact that US investors liabilities are mostly tied to the dollar. The downside of such conservatism is that it may also cause an investor to miss out significantly on positive developments in the international market like the rise of emerging markets (beware: the opposite also holds true).
Although currency diversification through international equities investing is often perceived as a risk, it can prove to be advantageous over the next few dacades. While the exchange rate between developed market currencies (US$, Euro & Yen) tend to mean revert every 10-15 years, one can take advantage of the divergence through periodic rebalancing (an important topic to be covered later). As far as emerging markets are concerned, these countries have over the last few decades excessively diluted their currencies to boost exports to the developed world but as the domestic markets in these countries mature and their politicians realize currency appreciation to be an effective way to tackle inflation & boost the purchasing power of its population, the phenomenon can serve as a return booster for foreign investors in these equities.
So in my personal view an asset allocation strategy based on the Gross Domestic Product (GDP) of various regions may be more rewarding considering the predominant home country bias. So a sample distribution can be: US (+ Canada) -> 35%, Europe -> 23.5%, Pacific -> 11.5% & Emerging Markets -> 30%. As before, investors can tactically adjust each category by (1 - 10% points) based on their risk preference & judgement about relative attractiveness of these markets.
Style: Equities can be classified into Growth & Value based on certain characteristics of a stock. While there is no standard definition, stocks trading at a high P/B, P/E or P/CF multiple are termed as growth stocks. They usually represent solid flourishing companies like Infosys, Dabur, Google, L&T, etc. A typical growth investor likes to see the sales/earnings grow faster than the bacterical multiplication rate or a strong brand equity and they don't mind paying extra for such companies. On the other hand value stocks represent stocks trading at low P/B, P/E or P/CF multiple. These companies are usually sick puppies or slow growing companies with poor management, negative earnings outlook or a crushing debt burden like Indo Rama Synthetics, India Nippon Electricals, Tanfac, Ceat, etc. A typical value investor has the mentality of a bean-counter and he is more concerned about not overpaying for a company's stock. There are also in-between categories like GARP (Growth at Reasonable Price) which are a concoction of these two styles in different proportions.
As far as returns are concerned, value stocks have offered higher returns than growth stocks over the long-term. Academics attribute the higher long-term returns of value stocks to their risky nature resulting in their price being overly depressed during bad times. Eventually the companies figure out a way to grow again or get acquired by a savvy competitor which brings their price back to normal. The growth stocks as a company do perform well but are generally priced so high that investors don't get enough bang for their buck. However similar to size, this outperformance of value stocks does not happen in all time-periods and market goes through alternate cycles of several years where one category outperforms the other (e.g. In US growth stocks were the cynosure of all eyes in 1980s & especially the 1990s but value stocks ruled the roost in 2000s). Today the conventional wisdom seems to be so much tilted towards value in US (the story is a bit different in India though) that it is hard to find a well-known courageous soul who identifies himself/herself as a growth investor.
I think a sensible investor under normal circumstances (prevails at most times except when growth stock gets priced disproportionately high, e.g. Nifty-Fifty craze in early 1970s & Tech mania in late 1990s) can just take a pass in this growth vs. value contest and own the overall market (which essentially includes both growth & value) for their core portfolio.
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