One of the first practical lessons in investing is that a well-constructed portfolio means one that is appropriately diversified. The standard form of diversification is through combining asset classes - such as bonds and property funds - with equities. However, this is not necessarily enough to reduce or optimize portfolio volatility. Diversification by management style is often the missing link in getting the right mix.

20 Tools For Building Up Your Portfolio
What Is Your Risk Tolerance?
Top 10 Green Industries
6 Ways To Make Better Options Trades
10 Options Strategies To Know

What exactly is investment style?

In this investment context, a style can be defined as the method that managers use to buy stocks or other assets. Newcomers to the investment business are often surprised at the very considerable variation and latitude in style and its powerful impact on performance at a given time and over a period of time.

According to Shawn Menard, writing in the Canadian Investment Review ("Risk Management: A Dynamic Process", 2000), this remains an underrated but extremely useful means of spreading risk. The deliberate use of variations in investment style as a means of reducing volatility is gaining considerable acceptance in the investment world; many believe that a symbiotic blending of management styles is an important part of the diversification process.

So-called "style rotation" has arguably become even more important in the new millennium, as the conventional equity-bond split has lost effectiveness through global capital market integration. Stylistic differences between money managers lead to a low correlation between or within asset classes that are managed with varied approaches. This is extremely valuable at a time when globalization tends to iron out differences between asset classes and many international markets are increasingly moving in tandem.

Offers and Guarantees of Style Diversification

Several investment advisory firms from around the world have developed plans to diversify their clients' portfolios across asset classes, within asset classes and across investment management styles. In the same way that different asset classes perform better and worse at different times, so too do varying approaches to management within these asset classes.

Some funds specify diversification in terms of style and guarantee to hire a certain number of managers with varying styles. Some, for instance, might promise a minimum of five separate managers, providing different and complementary strategies of equity investing.

The Main Styles

Value and Growth

The two classic stock-picking styles are those of value and growth. The value style entails buying stocks that are regarded as cheap, whereas growth stocks are expected to grow faster than the rest of the market. These two basic methods are quite different and, by having funds with both styles, investors are able to enjoy the best of both worlds. Particularly over the longer term, investors are likely to find that volatility can be reduced by mixing investment styles.

Momentum

Apart from these two classics of value and growth, there are several other fundamentally different approaches to the market. The momentum strategy is one. The idea behind this approach is that investments that have been doing well in the past and have gathered "momentum" are likely to continue doing well. Of course, it is necessary to figure out when the momentum will slow down or come to a halt.

Market Capitalization

Another form of style is the relative emphasis on market capitalization - small-, medium- or large-cap stocks. By shifting the allocation toward one size of company and away from another, very different results and performance can be obtained. In the extreme, small caps may be doing really well as a whole, while their big brothers take a loss. This is what diversification is all about.

Top-Down and Bottom-Up

Another important stylistic differentiation is between top-down and bottom-up approaches. The former entails looking at the "big picture", or the broader economic and financial scenarios, both locally and internationally, and only then moving "down" to consider specific sectors and, finally, the stocks of specific companies. Bottom-up is the opposite approach, where the focus is first and foremost on individual stocks. The basic assumption here is that good companies and their equities will thrive, even if market conditions are not particularly favorable.

Quantitative Approach

The quantitative approach is another possibility, and it relies heavily on computers for mathematical and statistical modeling. The idea is to remove all emotions from the process and have a computer check through enormous amounts of data to discover unrealized asset potential. This is, therefore, a purely technology-based means of stock picking or of asset selection. There is no shortage of such methods, but in the emotion-laden markets, which still depend heavily on people and their perceptions, computers have their limitations.

Keeping an Eye on Styles

As is the case with other assets classes and sectors, rebalancing between investment styles also makes a lot of sense. It is important to monitor and evaluate whether your style mix is performing optimally and to change it where appropriate. In other words, style should be treated like any other asset that evolves over time.

It is not uncommon for managers to not always remain true to their styles. For this reason, it is also necessary to monitor how closely managers adhere to their stated styles.

Conclusion

There are many way of diversifying a portfolio. One of these is through combining funds that operate according to fundamentally different investment styles. Although most people think of diversification as combining asset classes, similar or better results can be achieved though a sensible mix of value and growth stocks, bottom-down and top-up approaches, and so on.

The object of diversification is to achieve a good rate of return at an acceptable level of risk. Precisely this can be achieved by accepting and operating on the fundamental reality that asset management in the broadest sense, and not just the choice of assets, is critical.

Furthermore, whatever approach is favored, it is important to note that different styles may work better at different times, within different market structures and with different managers. Portfolios can be optimized through exploiting these differences through actively monitoring and mixing styles according to the prevailing situation in the various investment markets open to you.

Other articles in this week's newsletter

Aussie Property - Safe as Houses, or a House of Cards?

18 Share Tips - 19 April 2010

Silver bull has further to run

ROA And ROE Give Clear Picture Of Corporate Health

What is the loan to value ratio of a share, and how does this change as the share price changes?

Stock of the Week

Is Your Investing Style Hot, Or Not?

The 5 Factors Of A "Good" Property Location

US Dollar Likely to Rally Further if S&P 500 Declines

Market data - NEW

More breaking news