Portfolio ClassificationsMutual Funds
Mutual Fund portfolios vary in their risks and rewards based on the investments that compose the fund. In order to understand portfolio classifications, you must comprehend the three traits they are categorized from. These are value investments, growth investments, and capitalization size. Value funds use value investments while growth funds use growth investments.
Portfolio Classifications: Value Investments
Value Investments are selected on the basis of providing solid firms selling near or below the long term value estimated to be generated from their operations. By attempting to purchase shares below or close to their value, managers are avoiding purchasing firms which are overvalued. Overvalued firms have increased danger of suffering a “price correction” where they return to their real worth, resulting in sharp losses for whoever purchased at high prices. This technique avoids that risk by picking firms unlikely to have problematic futures.
Portfolio Classifications: Growth Investments
Growth Investments are selected on the basis of their ability to provide long-term growth capital. These are usually risky firms which have a lot of room to grow, but only if they can overcome the substantial challenges in front of them. These investments often take risks in order to acquire growth in the marketplace. If these risks pay off, the result is growth. If they fail, the result is often bankruptcy.
Portfolio Classifications: Capitalization Size
A firm’s capitalization refers to the total value of all shares for sale on the market. It’s important to note these are released shares, also known as shares outstanding. Large firms have grown over a long period of time, usually decades, and have stable wide reaching markets. They can resist volatile markets or economic downturns better than lesser competitors. Smaller firms are usually younger firms which don’t have wide market share. These firms are highly susceptible to market volatility or economic downturns in the since they do not have large market share or established branding.
Portfolio Classifications: Putting It All Together
Funds are classified by their mix of value investments, growth investments, and capitalization. The safest funds are Value Funds constructed from large, stable, value investments. These investments are composed of firms that are less likely to go bankrupt or implode. The riskiest funds are Growth Funds constructed from small, volatile, and growth oriented investments. These investments are made from companies constantly jostling for position against stronger competitors, making them more likely to suddenly go bankrupt and disappear. The chart for portfolio classifications is below.
You should first note that the investment strategy changes moving from left to right, increasing in risk as you move further right. Far left holds the lowest risk investment strategies, and far right holds the highest. The capitalization size of the firm decreases while moving from top to bottom, increasing in risk as it moves downward. The lowest risk in each category is large firms in the top row, and the highest risk in each category is the small firms in the bottom row. This shows the lowest possible risk is the top left box featuring large capitalization value firms, and the highest possible risk is the bottom right box featuring small capitalization growth firms.
This also opens up viable strategies that can be considered for building your overall portfolio of mutual funds. If you are attempting to capture increased gains at higher risks you focus a majority of your fund portfolio in growth or growth oriented blends, primarily towards funds in middle or small capitalizations. If capital preservation is your sole objective you focus your energy on the value and value oriented blends, primarily towards the large end of the grid. If you want a truly balanced portfolio, you would start by investing in the four corners of the grid, then move inwards to filling the middle sections.
You should be careful to avoid substantial fund overlaps. Overlaps occur when many funds are invested in the same investment instruments. If multiple funds share investments that decrease in price, all of the funds will be affected by the loss. Investing in the four corners of the chart attempts to avoid this problem, diversifying away this risk. When you decide to fill the middle sections, especially with capitalization or any blended fund, ensure that your funds are not all heavily invested in precisely the same equities and bonds.
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