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Should You Diversify by Stock Size and Style?

New research backs up the importance of diversifying your stock holdings.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. We've seen a resurgence in value stocks and smaller companies during the past several months, leading investors to wonder how they might effectively diversify across variety of different market caps and investment styles. Joining me today to discuss some fresh research on the topic is Amy Arnott. Amy is a portfolio strategist with Morningstar.

Hi, Amy. Thank you for being here today.

Amy Arnott: Thanks, Susan. It's great to be here.

Dziubinski: So, you recently coauthored a paper looking at the correlations of a variety of different market capitalizations and investment styles against a broad U.S. equity portfolio. But let's start out by defining our terms. What are correlations?

Arnott: So, we use a statistic called correlation coefficient, which measures how two different assets tend to move relative to each other. Are they always moving in the same direction, which would be a correlation of 1.0? Do they have basically no relationship, which would be a correlation of 0? Or do they move in the opposite direction, which would be a correlation of negative 1? And if you are trying to reduce risk and build a diversified portfolio, lower correlations are usually better. But one thing to keep in mind is that the correlation coefficient only captures the direction of returns and not the magnitude. So, if I have two investments, they might have a high correlation, but their returns could still be different.

Dziubinski: So, let's talk a little bit about correlations specifically between, let's say, the value and growth styles and different market capitalizations, versus a broad U.S. equity portfolio. How have those correlations looked historically?

Arnott: So, when we look at investment styles, we are using the Morningstar Style Box grid, which divides the U.S. equity market into nine different boxes based on investment style and size, but all of those smaller groups are still part of the U.S. equity market. So, it shouldn't be surprising that historically all of the nine Style Box squares have had pretty high correlations with the U.S. market overall, although the small value corner can be a little bit more idiosyncratic.

Dziubinski: And then did this pattern hold in 2020's bear market too?

Arnott: So, you've probably heard the saying that all correlations go to 1 in a bear market, and that definitely held true in early 2020. We saw a spike in correlations kind of across the board early last year, and all nine of the Style Boxes had correlations of close to 1 with the overall market.

Dziubinski: And you did comment in the paper that even though correlations did all increase in the bear market, there was a pretty good difference in the returns of the various parts of the Style Box, right?

Arnott: Sure. So, stocks suffered losses pretty much across the board, but some areas did hold up a little bit better than others. There was definitely a flight to quality. So, large-growth stocks held up a bit better with an average loss of about 30%, versus closer to 47% for small-value.

Dziubinski: And you also noted in the paper that when you look at the correlations across, or compared within, the Style Box to different styles against each other, that the correlations were lower in 2020. Is that right?

Arnott: Right. So, if you look at kind of the opposite corners of large growth and small value, the correlation was about 0.8. So, that's still pretty high in absolute terms, but definitely lower than either one relative to the overall market.

Dziubinski: Let's take a step back, Amy. What are the takeaways for investors here when it comes to portfolio diversification by the various parts of the Style Box? How should they be thinking about that going forward?

Arnott: I think these results really reinforce the importance of broad diversification. As you mentioned over the past few years, large growth was really a great place to be, but we have seen a pretty dramatic reversal over the past six months or so, with smaller-cap stocks and value stocks doing much better. So, if you are trying to build a diversified portfolio, you really want to make sure that you have exposure to different areas of the market and you are not too overweighted or out of balance in any specific area.

Dziubinski: Well, Amy, thank you so much for your time today and for these portfolio-construction tips. We appreciate it.

Arnott: Thanks, Susan. Always great to talk with you.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.