On U.S. Equities

Broad Portfolio Diversification Is Key to Moderating Risk

Donald Peters, Portfolio Manager in the U.S. Equity Division
Donald J. Easley, CFA, Portfolio Manager
Key Insights
  • A well-diversified investment portfolio is one of the best approaches for managing equity risk.
  • When investors overreact to short-term market volatility, it can undermine their returns and investment programs.
  • Our approach focuses on a broadly diversified portfolio of mid-cap companies with consistent earnings growth and reasonable valuations.

Investing in a well‑diversified portfolio is, in our view, an effective approach for managing risk and one that can potentially dissuade investors from making sudden allocation shifts. Our objective is to properly manage risk while seeking to outperform our competitors.

To use a baseball analogy, we seek to hit singles and doubles and reduce the likelihood of hitting into double plays. We’re not trying to hit three‑run homers with lots of double‑plays and strikeouts. A diversified strategy can make sense for investors seeking growth while trying to reduce, though not eliminate, volatility. Indeed, it’s important to note that periods of volatility can benefit investors in mutual funds by permitting the fund manager to purchase shares of valuable companies at a “discount.”

How We Add Value

In managing the Diversified Mid-Cap Growth Fund, we try to add value in several ways:
 

  • First, rather than trying to predict short‑term movements in the market, we maintain a nearly fully invested position in stocks. Our cash position is typically only about 20 basis points of assets to take advantage of opportunistic purchases. Many of our competitors’ cash positions are often 2% or higher depending on their short‑term market expectations. Trying to anticipate short‑term swings in the stock market, in our view, has a low probability of long‑term success because the manager must be right twice—when to sell and when to reinvest.
Blue Line

20 basis points

Our typical cash position.

  • We make very modest sector tilts in the portfolio. Making big bets on one market sector versus another is the first cousin to market timing, so we keep our sector positions in line with those in the Russell Midcap Growth Index. Playing the sector rotation game is extraordinarily challenging. In 2018, the best-performing sectors were technology—a very aggressive sector—and utilities—a very defensive one. That would have been very difficult to predict.
  • Stock selection is where we can add the most value, leveraging the insights of our analysts who routinely visit with companies in their industries. This is certainly key to identifying opportunities across the capital structure. Mid‑cap companies have more proven business models than smaller companies, but they are not as mature as many large‑cap companies, and it’s often not clear who the long‑term winners will be.
  • We invest in a broadly diversified portfolio that typically consists of about 300 companies with proven business models at what we believe are reasonable valuations. Companies that demonstrate consistent earnings growth regardless of economic conditions tend to be more stable than companies whose earnings are more variable.
  • We also eliminate those companies that fail to meet our expectations. The higher-quality mid‑cap companies are also occasionally acquired by larger companies looking to enhance their growth.
Opening Quote Stock selection is where we can add the most value, leveraging the insights of our analysts who routinely visit with companies in their industries. Closing Quote
— Don Peters, Co-portfolio Manager, T. Rowe Price Diversified Mid-Cap Growth Fund

Keeping a Close Eye on Valuation

Finally, we pay close attention to a company’s absolute and relative valuation to avoid paying an unreasonable price for expected growth. We do not chase “momentum” stocks whose excessive valuations are unsustainable and likely to decline at some point if growth expectations are lowered.

We also believe our long‑term investment horizon creates a strategic advantage. We invest in companies we expect to hold for several years, and our turnover rate is typically far below the average for comparable funds. It is not unusual for our portfolio to hold companies for a decade or longer, though the average holding period is about four years.

Diversified Mid-Cap Growth Fund

Sector Diversification1
As of December 31, 2018

Diversified Mid-Cap Growth Fund Sector Diversification

1 Percent of equities.
Source: T. Rowe Price.
T. Rowe Price uses the current MSCI/S&P Global Industry Classification Standard (GICS) for sector and industry reporting. T. Rowe Price will adhere to all updates to GICS for prospective reporting.
Numbers may not total due to rounding.

Our approach also combines the strengths of quantitative techniques with fundamental research to identify attractively valued companies with developed, stable businesses. Quantitative techniques can enhance portfolio management by analyzing the trade-offs between risk, return, and transaction costs for each holding. We believe portfolio construction and structure, along with stock selection, are keys to achieving long‑term success.

Investors can obtain the benefits of broad diversification by investing in funds that seek to replicate a particular market index, taking a so‑called passive investing approach. However, they should compare that with well‑diversified, actively managed funds that have achieved superior long‑term performance, with comparable or less volatility. Of course, diversification cannot assure a profit or protect against loss in a declining market.

Opening Quote Trying to anticipate short-term swings in the stock market, in our view, has a low probability of long‑term success… Closing Quote
— Don Easley, Co-portfolio Manager, T. Rowe Price Diversified Mid-Cap Growth Fund

Important Information

Download a prospectus.

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of March 2019 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

All funds are subject to market risk, including possible loss of principal. Because the fund invests primarily in securities issued by mid-cap companies, it is likely to be more volatile than a fund that focuses on securities issued by larger companies. Medium-sized companies often have less experienced management, narrower product lines, more limited financial resources, and less publicly available information than larger companies. In addition, smaller companies are typically more sensitive to changes in overall economic conditions and their securities may be difficult to trade. Because growth stocks have higher valuations and lower dividend yields than slower-growth or cyclical companies, the fund’s share price could decline further in market downturns than non-growth-oriented funds. The fund’s growth investing style may become out of favor, which may result in periods of underperformance.

MSCI and its affiliates and third party sources and providers (collectively, “MSCI”) makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

T. Rowe Price Investment Services, Inc.

© 2019 T. Rowe Price. All rights reserved. T. Rowe Price, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

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