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Spreading risk through diversification

Previously, we argued that investing according to forecasts from economists and experts has a lower probability of making money as compared to holding a simple, globally-diversified index fund. Here, we explain why a globally-diversified index fund is superior to a concentrated portfolio of Singapore stocks.

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Previously, we argued that investing according to forecasts from economists and experts has a lower probability of making money as compared to holding a simple, globally-diversified index fund. Here, we explain why a globally-diversified index fund is superior to a concentrated portfolio of Singapore stocks.

Financial investments are a journey. If we look at investment vehicles, they come with shock absorbers that help to reduce the bounce effect from road bumps. While you could drive a vehicle with a broken suspension and still reach your destination, you would have to endure an uncomfortable ride and take on some degree of danger.

Applying this analogy to investing, the rough and unpredictable “shock absorber-less” ride is the prospect faced by an investor who holds concentrated, undiversified assets. This is particularly true for investors who buy assets because of a “hot tip”, but are oblivious to the magnitude and extent of loss during a market downturn. 

Obviously, the smartest thing for any investor to do would be to beef up their investment portfolio “shock absorbers”. How do you achieve that? 

For starters, you will need to diversify your investment holdings, which means that instead of holding three or four Singapore stocks, it would be better to spread over several different securities, sectors and countries. This can be efficiently achieved by buying a global equity index fund, or a large portfolio of stocks representing a spread of countries.

BENEFITS OF DIVERSIFICATION 

Many Singaporean investors hold Singapore stocks only. This is known as a home bias, where investors feel more comfortable holding stocks in their home country. But the Singapore market comprises only 0.4 per cent of all the stocks listed globally. If an investor focuses purely on Singapore stocks, he is foregoing the potential returns of 99.6 per cent of stocks from the rest of the world.

On top of that, the investor would be taking on the full brunt and singular exposure of the Singapore economic cycle. On the other hand, a global stock portfolio offers an investor exposure to a wider range of economic cycles and, more importantly, a range of different stock returns from a large number of countries. Investors with global exposure can avoid tepid returns should the local economy stall.

Another major benefit of diversification is the reduction of risk. The typical volatility of the Singapore stock market is approximately 25 per cent. Global stocks have a volatility measurement of about 16 per cent. The long-term return of the Singapore stock market is approximately 8.5 per cent per annum, with global stocks at 8 per cent per annum. 

To measure the amount of return an investor receives for every unit of risk taken, we can apply the Sharpe ratio, which calculates risk-adjusted return. By this measure, global stocks have a metric of 0.40 (return per unit risk taken) versus 0.26 for the Singapore stock market. This means that investors are better off holding global stocks for a better risk-adjusted return. An investor looking only to maximise returns would choose the Singapore market.

Another benefit of diversification is that it helps investors achieve returns without the need to guess where, when and what to invest in.

In 2015, the Danish stock market was the No 1 equity performer with a return of about 23 per cent. Investors who then piled into Denmark ended up being bitterly disappointed as the Danish stock market lost 16 per cent the following year. Investing steadfastly in global stocks during this same period would have netted a range between -2 per cent and 8.5 per cent.

WHY ASSET ALLOCATION AFFECTS INVESTOR BEHAVIOUR

Investors must also identify the appropriate mix of different assets, such as stocks, bonds and real estate, to form a suitable asset allocation for their personal risk tolerance. Although it sounds rudimentary, many still end up holding the wrong type of assets, in the wrong mix, only to suffer losses when they sell in panic at the wrong time.

Most financial advisers either do not spend enough time talking about risk or are themselves oblivious to risk. Ask your adviser about the risk of a fund or portfolio, and many will merely quote its volatility figure. A metric known as the Value-at-Risk (or VaR) is a better measurement, as it indicates the potential loss an investor might suffer in a specified time period.

The promise of better returns should always be weighed against the higher risk potential. A global stock portfolio typically has a one-year VaR of 18 per cent. This means that the potential loss on a S$100,000 investment is likely to be capped at S$18,000 in a given year. In a balanced portfolio with half in global stocks and the other half in global bonds, for example, the one-year VaR is about 10 per cent. Using this method of risk evaluation, an investor can assess his level of comfort with the magnitude of potential loss.

Going back to the car analogy, if you have driven long distances, you will know that road conditions can change very quickly and sometimes without warning. That is why you need a vehicle that is robust and equipped to handle all road conditions. 

This is the same with investing. It is important that investors consider the benefits of diversification and proper asset allocation. While these two factors do not iron out every bump in the investing journey, it does help to smooth out the more serious bumps.

ABOUT THE AUTHOR: Aw Choon Hui is the deputy CEO of GYC Financial Advisory, a licensed financial adviser and registered fund management company.

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