Managing risk with sector diversification
SINGAPORE--By virtue of low interest rates, moderate inflation and a stable currency, financial conditions in Singapore maintain a case for share investing. Investors must be aware, however, that it is never wise to put all of one’s eggs in one basket and invest all of one’s life savings in one stock. Different stocks display different price performances, and investors must choose their stocks carefully.
The most effective way of reducing risk related to stock performance is to build a diverse investment portfolio – to choose stocks that belong to different business sectors. Some investors may find the selection of different stocks a complicated undertaking. However, examining the performance of individual business sectors can provide guidance on where to begin.
A typical trading day on the Singapore stock market will see the top 10 stocks by turnover represent five or six different business sectors. The performance of these sectors, among others, can be summarised by the FTSE ST Index Series, which includes 12 distinct indices tracking the major business sectors.
To illustrate how the varying performance of different stocks can affect a portfolio, consider the 2012 performance of these 12 sector indices. The FTSE ST All Share Index, which is made up of all the 166 stocks that also make up the 12 different sector indices, generated a total return of +26.4 per cent last year. However, this figure comprised both positive and negative results.On one end of the spectrum, the FTSE ST Real Estate Holding & Development Index generated a total return of 59.4% , while on the other end the FTSE ST Consumer Goods Index (with dividends included) declined 15.8%. In total, two sector indices declined and 10 sector indices generated gains. The +26.4 per cent gain seen by the FTSE ST All Share Index was made possible because total gains from individual sectors offset declines.
This principle applies to individual stocks too. As an example, consider an investor who chose to invest equally in three specific stocks: firstly Wilmar, the largest stock of the FTSE ST Consumer Goods Index in 2012;secondly Keppel Corp, the largest stock of the FTSE ST Oil & Gas Index; and thirdly SingTel, the largest stock of the Telecommunications Index.
At the very end of 2011, the portfolio would have been almost balanced with Wilmar making up 35 per cent of the portfolio with 2,000 shares at S$5.00 each, Keppel Corp making up 33% of the portfolio with 1,000 shares at S$9.30 each and Singtel making up 32% of the portfolio with 3,000 shares at $3.09 each. The total portfolio would be worth S$28,570 at the end of 2011.
During 2012, Wilmar depreciated 33.2 per cent, Keppel Corp appreciated 18.3 per cent and Singtel appreciated 6.8 per cent. Dividends were added to total returns and in the case of Singtel, 3,000 shares generated S$474 in dividends. In terms of Singtel services, that is equivalent to nine months of minimum monthly subscription payment on the current flexi value Samsung Galaxy Note plan. At the end of 2012, the portfolio would have marginally increased in value to S$28,596.
The performance of this portfolio illustrates the importance of diversification. By choosing stocks from three different business sectors, the investor did not become excessively exposed to an underperforming stock. Even though the underperforming sector made up the largest part of the portfolio, its losses were offset by the performance of the two other stocks that gained.
Diversification is thus overall a more recommended strategy for investors who seek long-term capital gains. In contrast, focusing on a single stock or sector in anticipation that it will outperform all other stocks or sectors is typically reserved for active traders or speculators.