The longer I do this, the more I mistakenly assume a certain amount of basic investing knowledge among those I interact with. So from time to time I like to step back and go over some basics to make sure everyone has that basic level of knowledge. In this post, I'd like to talk a little bit about stocks and the publicly traded stock market. A great tool for understanding this has been available from Morningstar (absolutely free) for years called the “Instant X-ray Tool.” If you have never really plugged your portfolio into this tool, you're missing out on a great opportunity to understand what you actually own.

Before we go there, however, it is first important for you to understand the way Morningstar, and indeed most reasonably sophisticated investors, look at the stock market. A common tool is what is now known as the Morningstar Style Box. For stocks, this style box looks like this:


Along the X-axis, the stock market is defined as either Value or Growth, with the two types of stocks blending in the middle. A good way to think of a value stock is to think of something that isn't sexy or thought to be a good company, but which can be bought at a very good price. And when I'm talking about a good price, I'm talking about a low price for the amount of earnings the company gets. This is often measured by a Price/Earnings ratio. A good example of a value stock is General Motors. Nobody gets excited about buying General Motors stock. In fact, there have been times in the past when it nearly went out of business. It's P/E ratio right now is about 4, so that means you only need to pay $4 to get $1 of earnings. On the other side is a Growth stock. These are stocks that everyone has heard of, companies that are growing rapidly and are expected to keep growing rapidly. We're talking about Apple, Google, Facebook, and Disney. Google, aka Alphabet, has a PE ratio of 30. So you pay $30 for $1 of earnings. But Google is obviously far more likely to grow its earnings in the next year than GM is.

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Along the Y axis, the stock market is divided into large cap, mid cap, and small cap companies. Large cap companies are all the companies you've heard of, like Apple, Exxon, and similar. The entire S&P 500 is essentially made up of large cap companies. They generally have a market capitalization (multiply number of shares by the price per share) upwards of $5 Billion. A mid-cap company has a capitalization of $1-5 Billion, and a small cap company has a capitalization of less than $1 Billion. At the very top end, they might use the term “Mega-cap” for the largest companies, and at the small end they may use the term “micro-cap.” While micro-cap seems like it would be a very small company, and they often only have one product they make, they generally have capitalizations of $50-300 Million. If you start a company and grow it to $50 Million, you'll feel pretty successful, but in the publicly traded markets, that's a darn small company.

Now that you understand what Morningstar is doing, it can be fun to look at what the chart looks like for some popular mutual funds. Let's start with Vanguard's Total Stock Market. This is a fund designed to track the entire US publicly traded stock market, large and small cap, value and growth stocks. Here's what it's chart looks like:


The shaded area represents where all the stocks this fund holds fall on the Morningstar style box, and the target symbol gives you a bit of an average. The stocks range from Gigantic companies to larger small-caps and from very valuey companies to very growthy companies. But on average, it is basically a large cap, slightly more growth than value holding. By percentage, if you put money into this fund, these are the percentages of each type of stock that you have just bought:


As you can see, the fund is 72% large cap, 18% mid-cap, and 9% small cap. It is 34% growth, 33% blend, and 32% value. If you own the market portfolio, that's what you own.

Some academics have made very good arguments that over the long run small stocks have higher returns than large stocks and value stocks have higher returns than growth stocks. This is usually argued on the basis of risk. Both value stocks and small stocks are far more likely to have a bad year or go out of business all together than a large growth stock. But because of this, many investors have decided that they want to “tilt” their portfolios toward small and value stocks. How much of a tilt you want really depends on how much you believe that the future will resemble the past in this respect. Obviously, by putting more of your portfolio into the 3% of the overall economy represented by small value stocks you lose some diversification, but “factor” or “smart beta” investors argue that diversification by risk matters more than the sheer number of companies you own. They argue that diversifying by “market” risk, “size” risk, and “value” risk gives you MORE diversification than matching the market portfolio. Reasonable people disagree on this, but if you do buy into this argument, your portfolio won't look like the one above.

Now, let's get to the Morningstar X-ray Tool. Just for fun, we'll plug my portfolio into this. We'll just do it for US stocks to keep it simple. They make up about 1/2 my portfolio, which looks like this:

  • 17.5% Total Stock Market Index Fund (mostly large caps)
  • 10% Extended Stock Market Index Fund (mostly mid-caps)
  • 5% Large Value Stock Market Index Fund (mostly large value stocks)
  • 5% Small Value Stock Market Index Fund (mostly small value stocks)
  • 5% Bridgeway Ultra Small Market Fund (small and micro cap stocks)
  • 7.5% REIT Index Fund (REITs are mostly mid and small cap value stocks)

Here's what it looks like when you plug it into the X-ray Tool:


You can do it by dollar value or by percentage. I just used nice round numbers to make it easy. Then you click the “Show Instant X-Ray” button and this is what you get.



As you can see, that's quite a bit different from the total market portfolio. I have 4 times as much small value stock as the market portfolio, for instance. Where the market portfolio has 18% in mid caps and 9% in small caps, I have 27% and 32%. As you can see, I'm making a pretty significant bet that small will outperform large stocks over my investing career and a smaller bet that value stocks will outperform growth stocks. (An academic would argue the value effect is larger than the size effect and I should have reversed these bets.)

The tool also tells me that my overall expense ratio is 0.14% per year, and says that's a lot better than a “hypothetical similar portfolio” which it says has an expense ratio of 1.15% per year. But the Vanguard Total Stock Market Index Fund has an expense ratio of just 0.05% per year, so my bet has a cost to it of at least 9 basis points per year. Costs are guaranteed, and an extremely useful, probably the most useful, predictor of future long-term returns of a given fund, but 9 basis points isn't very much. I'm still basically paying 1/10th of what most investors are, and that's not even including advisory fees, so I'm not that worried.

One of the most useful things about the X-ray tool is for someone who isn't investing in index funds. A lot of times they plug the ticker symbols of what they own into the X-ray tool and realize that despite thinking they were diversified because they own 20 different mutual funds, they have really just recreated the market portfolio at 10 times the price.

What do you think? What does your box look like? Is that what you intended to invest in? What did you learn by this exercise? Comment below!