It has been said that diversification is the only “free lunch” in investing. I’ve found that most investors have a poor understanding of what it means to maximize their diversification. The first level of diversification is across asset classes. For example, a diversified portfolio might hold US stocks, international developed market stocks, emerging market stocks, real estate trusts, commodity futures and global fixed income investments.

The second and less understood level of diversification is across style premiums (also called return premiums or risk premiums). Style premiums offer a different category of risk/reward, generally outside the “traditional” asset classes. They implement a rules-based, methodical strategy that is observed in the marketplace over long periods of time. For example, the size premium captures the additional risk and additional reward by favoring small cap stocks versus large cap stocks. Below is a list of style premiums that will be profiled in this blog:

1. Equity premium
2. Size premium
3. Value premium
4. Momentum premium
5. Term premium
6. Default premium
7. Profitability premium

Note that there are other premiums that have been “discovered” in academia. However, we do not use them in building our clients’ portfolios as there are no suitable investment vehicles to capture them. Some examples are:

1. Currency carry premium
2. Volatility selling premium
3. Merger arbitrage premium
4. Low volatility premium