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.
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!
Very neat. Did you intentionally try to smooth out your size exposure so that your large cap exposure almost equals to your small cap exposure? I wonder how a portfolio consisting of equal exposure to each of the nine boxes would compare to the total stock market portfolio.
Great tool. I plugged in my US Stock funds, which are 60% of my portfolio.
37% Large Cap
44% Mid Cap
21% Small Cap
ER 0.07% comparre to 1.11% hypothetical.
Vanguard’s small cap index and value funds are 43% mid cap stocks according to the Instant X-Ray, which explains my mid-cap bloat.
This is a classic WCI post that will be very useful to many beginning investors. Bravo.
I might suggest you remove the REITs from your US funds instant x-ray analysis. If you run VNQ by itself we see an overall midcap blend, but significant growth tilt, particularly in the large cap space.
I think it’s better to think of REITs separately so they don’t contaminate the X-ray results. Same for international funds which tend to be even more large cap heavy.
What’s interesting is REITs used to be mid/small cap value stocks a few years ago!
I am a VTSAX man for my IRAs so the top chart is similar to mine, for my 401k we are with fidelity and I literally had to pick a Large and small cap index fund (I went 70% large) along with my RIETs. I will be interested to see the Value vs Growth blend and may be doing this later today.
Nice post! It’s always good to have a refresher and as always, knowledge is power…so keep giving us the power!
Bigcharts.com-You can compare your returns on the stocks and funds you own to the sp500 and other indices with their advanced search
You really want to see how u r doing if you are NOT INDEXING!!!
I agree. Benchmarking is kind of silly for an index fund investor but critical for a stock-picker or mutual fund manager picker. Still good to know what you own though, even if they’re all index funds.
I use personal capital and it tracks my net worth and tell me how much large, mid, small, and what size factor I have. Do I still need morningstar Xray?
No, you probably don’t NEED it. But it’s a free five minute exercise you do once, not an expensive monthly chore.
PC uses a morningstar API behind the scenes and allows some form of customization for unknown tickers
I’ve been drinking a lot of the small cap value koolaid. I hope it pays off in the long run.
IMO emphasis on “diversification” is a bit overblown these days. In b-school you learn modern portfolio theory and all that and statistics and studies indicate that you need to be invested in at least 20 different *stocks* to achieve sufficient diversification, i.e., something that is accomplishable with picking just *one* mutual fund. A lot of these financial blogs etc. advocate owning a menagerie of different mutual funds to essentially be diversified into every part of the market. In addition to the overlap between funds, the investor ends up buying a lot of losers along with the winners, and his or her portfolio has no clear strategy or spirit other than to try to minimize risk altogether, and ends up with only modest returns as a result.
Uh thats like 90% of people reading this blog and any other personal finance blog. If you change their minds you will be called out as a heretic. Brainwashing?
Give me a break. I run all kinds of guest posts from people with alternative viewpoints about how to invest. People who comment on this site invest in many different ways. But if I think what you’re is “less than optimal” (I’m told I shouldn’t say stupid as often as I do) I’m going to tell you. Not because I think I’m likely to change your mind, but because I don’t want someone wandering in thinking I (or most people) agree with it.
Wasn’t meant as an argument. All I was saying is that 90% of the personal finance blogs are regarding index investing and broad diversification. Which is what sounded like Craigy didn’t agree with (may be I’m missing something).
Different flavors I agree. Everyone is free to choose what to do with their money. I’m just beginning to read many blogs and IMHO its all index investing with some RE and some random investing in things that don’t make sense.
That’s all. Still learning.
There’s a reason most people who aren’t selling you something recommend index funds, including Craigy.
True but does that mean your recent newsletter mentioned how you are “Changing” your asset allocation. I am assuming these are private investments. Isn’t that sort of against the indexing recommendation though? Like someone in forums is getting shot down re: non-standard assets. Thats my point.
Personally I am at an impasse: stick with index fund only (as I said 90% of people) or go out there and do a good 25% alternative investments.
You read the newsletter, the blog and the forum? Are you stalking me?
Yes, I’ve made some recent AA changes. Mostly simplifying and cost-cutting. More details in a post coming up. The new X-ray looks pretty similar to the old one.
I don’t have a problem with 25% alternative investments. The forum thread you are referring to (and isn’t that “someone” you?) suggested a portfolio of 20 individual stocks and bonds and investing in Bitcoin. That I have a problem with.
I think the base of your portfolio ought to be built around stock and bond index funds preferably inside tax-protected accounts +/- income producing real estate properties. If you want to do some other stuff around the edges, I think that’s fine. I certainly do and plan to continue. But each of those deals must be analyzed carefully individually for its merits. There are very few investments that aren’t okay if they’re limited to 5% of your portfolio.
No way. 20 individual stocks is dumb. That is not me. And no way – bitcoin: 100% speculative.
https://www.whitecoatinvestor.com/forums/topic/non-standard-assets/
Thats the thread. Anyone can check what I said.
I am not stalking, simple trying to soak up info and yes I want to mold my strategy according to those who are years ahead of me. Part of internalizing is remembering. Read your newsletter this am and thought it was great. Specially the skiing part.
Looking forward to it.
Oh yea, it was 100 stocks. And obviously it wasn’t you. 100 is better than 20.
Actually, 100 is probably worse than 20. I can’t imagine managing all those.
The “20-30 stocks are enough” idea is really a bit of a myth. I’ve seen a few good articles explaining why, but this is the only one I could find quickly:
http://www.investopedia.com/articles/stocks/11/illusion-of-diversification.asp
The bottom line is that 20 isn’t enough.
But even leaving that argument for a minute, it’s not like buying 20 stocks is somehow easier than just buying them all. It’s far harder! At least 20 times harder, and that assumes you’re picking them with a monkey and a dartboard.
I agree with you on the difficulty level of picking stocks. Really, it’s not just a difficulty issue, but for people like you and me it’s a hubristic issue of thinking we are really stock market savvy enough to pick individual stock winners and losers in the first place. Which is why I invest in funds.
Understandably that’s just one article, but it seems like a decent representation of the general feeling that you *have to* invest in *every* industry, and within each respective industry you should be “diversified” with several stocks. Again, this concept is stated as something that every investor should be doing simply as a matter of course (and this seems to be echoed by many investors, bloggers, advisers). IMO this is ridiculous.
I wouldn’t personally advocate for someone to buy just 20 or 30 stocks, or just invest in a single fund, but the concept that you have to buy the whole market in order to capture all gains and minimize your portfolio risk as much as possible is silly. I vastly prefer your strategy and mine which overweights relative to the market certain sectors we feel will have higher-than-average returns in order to obtain better long-term results.
One paragraph from the article that I thought was funny. Again I understand that’s just one article which might not represent your beliefs, but it does shed a little light into the author’s mindset:
“You must ask yourself how realistic is it that you or your stock manager can identify the top performers before they perform? How unrealistic is it to pick a few stocks and for one of them to be the next Dell (Nasdaq:DELL) or Microsoft (Nasdaq:MSFT) at the early stages of their run? How realistic is that you end up with one of the almost 40% of stocks which lost money or one of the 18.5% that lost 75% of their value? What are the chances today that you have the undiscovered overachievers in your account? The global stock universe is huge. Ask yourself, how many stocks do you really need to capture any one specific area such as the energy sector or the financial sector? What if you only picked one and it was the one that went bankrupt? I doubt five per area would be enough, but for arguments sake, we’ll say five stocks are adequate per area to feel confident.”
Just using the ideas in the paragraph:
Sure, picking stocks you might miss out on the next Dell or Microsoft. But the proposed alternative is to buy the “global stock universe” wherein, you will 1) be purchasing that same 40% of stocks that lost money and 2) be purchasing the 18.5% of stocks that lost 75% of their value. Thankfully you will have those “undiscovered overachievers” in there to help you out, but given you’ve bought the whole universe, your million dollar portfolio only has about thirty bucks parked in that next Dell and Microsoft.
Eventually you diversify too much 🙂
Diversification protects you against what you don’t know.
Agree that the 20 stock thing is a bit of a myth, I think they say it gets you like 86% diversified, and that was in the past as well. Its not 100% and there is still all kinds of risk involved. Also agree that the slice and dice is mostly overlap and being sold as most premia have evaporated, I mean we all know about them now and everyone is doing it, it wont continue to do what it did in the past. A total universe fund US/Intl is more than enough.
Remember due to the nature of the indices its concentrates winners and throws out losers so while we call it “passive” it does whats needed. Its simply way too easy and the other way is far too much work and not guaranteed.
Nothing wrong with doing other things on the edges, I know I do but do limit it to a percentage of the portfolio.
Thanks for the clarity on this topic. I definitely understand it better.
I just put my portfolio in the Instant X-Ray and noticed the middle box on the X axis says “Core” not “Blend”. Are they equivalent terms?
Yes. They are equal. Read this if more interested http://www.investopedia.com/articles/stocks/07/style-investing.asp
Yes.
owning individual stocks purely is pure folly
For majority. Reading on the net, there are a few that believe in stock picking/value investing etc and have done well.
Does anyone use Morningstar premium subscription. The majority of their “premium benefits” would be useless to me, but I’m interested if any premium X-ray or portfolio analysis is helpful.
i.e. When I analyze international stocks, I wish it was easier to immediate calculate the % emerging markets (I know their are different definitions). Would love if I could see a calculated average portfolio market capitalization. Would like to see other portfolio metrics. Would like to more easily save portfolios, rather than re-enter. Etc…
I brought them on as an affiliate marketing partner like 5 years ago. Never made anything from it. Unless you’re a mutual fund manager picker, I see no reason to buy a premium subscription. And I don’t think you should be a mutual fund manager picker.
I have a premium subscription and read Morninstar every day (I need it to justify the research done on our large companies 401k plan, whose investment committee I oversee). But I agree completely that if you are going to be a primarily index fund investor there is absolutely no reason to spend the money.
In my opinion Morningstar does 3 things well:
1) Reviews of mutual funds and ETFs, helping steer people from putting too much into what should be non-core funds (such as putting 25% of their money in foreign corporate high yield debt, etc., and most importantly recommending alternative, cheaper/better funds in any given category.
2) Reviews of individual stocks, with pretty decent fair value analysis. I actually think this is Morninstar’s hidden strength, as their people driven analysis is among the best. But if you don’t pick individual stocks, then this is worthless.
3) Helping new retirees figure out some reasonable strategy to take their 401k rollovers and such and turn it into a reasonable plan of “buckets” from which to pay for their own self-funded retirement. Endless articles on this, and quite good on just basic financial planning topics.
Anyway, thoughts.
I had free access to the premium Morningstar stuff as a T. Rowe Price customer years ago. I don’t recall anything all that great. There’s a lot you can do for free.
I tried using the Morningstar X-ray for my TSP funds without success. It doesn’t seem they have a ticker symbol for TSP funds. Currently I only own the L2050 fund of the TSP, which changes regularly, so I’m not surprised that Morningstar x-ray doesn’t handle that fund. I use personal capital to monitor my asset allocation (I have HSA funds via TDA), which seems to track the TSP funds adequately, at least I hope so.
Anyone have advice for putting in TSP funds into Morningstar x-ray? For other people in the TSP, do you find that personal capital is adequate to track your asset allocation?
It won’t take TSP symbols, but you can use substitutes. Use Vanguard Total Bond Market for F, 500 Index for C, Extended Market Index for S, and Developed Markets Index for I. You can use Prime MMF for G (but it isn’t a great substitute.) If you don’t want to break down your L fund into its respective components, you can get close using a similar Vanguard Target Retirement Fund.
This post reminded me of your past post:
https://www.whitecoatinvestor.com/morningstar-com-a-review/
I’m new here, am catching up by reading all your old entries first, and am always glad for “back to basics” info.
Somewhat similar post. Good eye. It’s been a long time since I wrote that one!
I tend to place my investments on blend stocks, but I think I will be switching over to growth over the next 5 years. Does {small,mid,large}, {value, blend, growth} evaluation apply to government securities or only the stock market?
Only the stock market.
FYI- The long-term data shows highest returns for small value. Large value also gets a “premium” and large growth has provided decent returns. Small growth seems to be the black hole of the stock market- higher risk and lower returns.
As a general rule, those who subscribe to the research of Fama/French tilt in various degrees to small and value, with the default being the market portfolio. Assuming the future resembles the past, over the long run you would expect lower returns from “switching over to growth.” May reduce risk though.
Great post (per usual). It is always nice to see these “look at the forest” posts.
It was depressing to see that I have almost replicated the Total Market fund for an additional 0.06 basis points. I think it is because I have a significant weight (10%) towards the Vanguard Energy Fund and the majority of that fund is Large Cap stocks.
The end result is that I’m probably going to increase our percentage of Small Cap holdings with this year’s Roth contributions.
Do you use the Morningstar style box mostly for rebalancing or for implementing your asset allocation once it’s decided upon? Or both? It definitely seems more helpful if you’re an asset class “junkie” compared to a simple 3-fund portfolio. Thanks!
https://www.whitecoatinvestor.com/understand-what-you-own/
I don’t know that I use it for either of those things, more for general knowledge and understanding what I own. It’s pretty useful when you’re trying to simplify your asset allocation. You might realize that you can get the same x-ray with 3-4 funds instead of 10, all at lower cost and complexity.
Is the morningstar Instant X-Ray still free? It is asking me to pay for a subscription to use it. Thanks for the useful content…
Yes, you just have to access it through TD Ameritrade or give Morningstar your info.
https://www.tdameritrade.com/education/tools-and-calculators/morningstar-instant-xray.html