INGREDIENTS OF ASSET ALLOCATION

Investing has evolved over the last few decades. First, there is the shift away from individual stock selection toward diversification of stock holdings. Instead of choosing the 10 or 20 best stocks for the portfolio, an investment advisor is more likely to make sure the portfolio is properly diversified between different types of stocks. More specifically, the advisor deliberately balances different styles of stocks, choosing both growth and value stocks and large-cap and small-cap stocks. One reason for this shift in the approach to investing is the realization that investment styles go in and out of favor. For several years or more, growth stocks may outperform value stocks and investors become enthusiastic about new technologies (as they did in the early 1970s and late 1990s). But then value stocks thrive, and investors must switch their allegiances. This shift toward style investing was also driven by the discovery that value stocks provide a value premium over growth stocks and that small-capitalization stocks provide a small-cap premium over large-cap stocks. These premiums will be analyzed in detail in Chapters 3 and 4. Chapter 3 will show how small-cap stocks fit into the overall stock market and will present evidence about whether there is a premium for small-caps. Chapter 4 will examine value and growth stocks and present evidence on the value premium.

In the 1980s, investment in foreign equities gained favor. Capital controls had been ...

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