Investing Classroom: Core vs non-core investments

The core holding concept might not be the most exciting of ideas, but what core holdings lack in thrills, they make up for in importance. A core holding is just what it sounds like: It's the central part of your portfolio. The core requires investments that will be reliable year in and year out. They're the solid foundation for the rest of a portfolio.

To reach your investment goals, your portfolio needs a solid, reliable core. The rest is often frills.

What makes a core fund?

Large-cap blend funds, which own big companies with middle-of-the-road stock prices, are core stalwarts. Large-blend funds usually don't lead performance lists, but they're even less likely to bring up the rear. They're boring, which makes them ideal core choices.

For cautious investors, large-value funds used to be the preferred core holdings. These funds invest in big, well-established companies with stocks that are cheap relative to those of other large caps. Historically, that focus on slow-growing, generally steady companies earned large-value funds the lowest risk scores of any of the Morningstar style categories.

But those risk numbers are deceiving. In down markets, value-oriented funds often lose more money than their blend counterparts. Large-blend funds may be more reliable.

But wait. If large-cap funds are good core holdings, why not large-growth funds?

Large-growth funds don't have the best temperament for core holdings; they tend to have bigger mood swings than their blend or value counterparts. Their highs are nice--they mean higher returns--but when they're down in the dumps, that spells bigger losses than you might want at the heart of your portfolio.

If the allure of large-growth funds is just too powerful, go ahead and invest in one. But invest in an equal amount of money in a large-value fund, too. Owning both is about the same as investing in a large-blend fund.

You might want to include a foreign-equity fund as a core holding, too. That way, you aren't staking everything on the UK market. The fund should focus on the world's developed markets, investing in leading companies, just as your core UK funds do.

Finally, a bond fund might make a good core holding if your asset allocation calls for it. Stick with bond funds that invest in high-quality securities. Focus on those that favour the intermediate part of the yield curve. Why? Because the longer a fund's maturity, the more volatile its returns generally are. You can capture much of the return of a long-maturity fund with an intermediate-maturity fund, but with a lot less volatility.

Clearly, a fund that is a core holding for one investor may not be a core holding for another investor. However, Morningstar analysts do discuss what role a fund may play in a portfolio in the Role in Portfolio section of a Morningstar Fund Report. This can found in the lefthand column of this example.

What about core stocks?

If you're more into stock investing, your core should be made up of stable, blue-chip companies. As with funds, big and boring is the key to a core investment.

Great core stocks share a handful of qualities. For starters, they're profitable, consistently earning great returns on the money (or capital) shareholders have invested. The way we measure return on capital for companies is return on equity, or ROE. It's easy for a company to generate a large ROE in one year, though. Core holdings offer impressive ROEs year in and year out.

Core stocks are reliable growers. They may not be growing at the same pace that a new company is. But their earnings are predictable year in and year out, and they may even pay out earnings to shareholders in the form of a dividend.

Finally, core companies are also financially healthy. In other words, they don't take on a lot of debt. Moreover, they generate plenty of free cash flow, or cash flow after spending.

How big your core should be

Core holdings take up 100% of some portfolios. In others, these investments account for 70% to 80% of assets. There's no rule for how large your core ought to be. But we suggest that core holdings take up at least 50% of your portfolio. After all, you are relying on these solid, long-term investments to help you reach your goals.

So where do the rest of your assets go? Into non-core investments, or the supporting players of your portfolio.

Non-core holdings are the stop-and-go investments that may juice returns--sector funds, tech stocks, and funds run by managers who make large bets on particular holdings or on certain parts of the market. Small-cap stocks could also fall into that category for some investors, simply because they tend to be more volatile than large-cap investments.

Use non-core investments for diversification and growth potential. For instance, if your core is made up exclusively of large-cap stocks, you might want to add small-cap or international stocks to the non-core portion of your portfolio for diversification.

While you probably wouldn't want to put a significant portion of your portfolio in any one of these types of investments, they do allow for the possibility of extraordinary returns. Of course, they also generally carry a higher level of risk. But as long as you limit the more risky portion of your portfolio, you aren't likely to threaten the bulk of your nest egg--and your investing will be more adventurous.

Just don't forget to put together a reliable core first. You don't want more thrills than your portfolio can stand.