Spreading investment risk through diversification

An edited version of this article was published in the 8 May 2017 print issue of TODAY. (Online version released on 6 May.)

In our previous article, “Follies of Forecasting”, we argued and presented evidence that investing according to forecasts from economists and market experts has a lower probability of making money as compared to holding a simple, globally-diversified index fund. In this article, we explain what a globally-diversified index fund is, and why it is superior to a concentrated portfolio of Singapore stocks.

What do the shock absorbers in a vehicle do? The short answer is that they help to reduce the bounce effect from bumps in the road, as well as keep the tyres on the road. 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 throughout the drive.

Applying this same 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 who 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’ll need to diversify your investment holdings, which means that instead of just holding three or four Singapore stocks, it would be better to spread that same capital 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 in the world.

Benefits of Diversification

Many Singaporean investors hold Singapore stocks only. In investment terms, this is referred to as a home bias, where investors feel more comfortable holding stocks in their home country which they are familiar with. But the Singapore market comprises a mere 0.4 per cent of all the stocks listed globally. Thus, an investor who focuses purely on Singapore stocks would effectively be 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.

Singapore investors with global exposure can avoid tepid returns should the local economy stall. A diversified portfolio thus makes for a much smoother ride.

Another major benefit of diversification is the reduction of risk. The typical standard deviation, or volatility, of the Singapore stock market is approximately 25 per cent. Global stocks, on the other hand, have a volatility measurement of around 16 per cent. The long-term return of the Singapore stock market is approximately 8.5 per cent per annum, with global stocks coming in at around 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 superior metric of 0.40 (return per unit risk taken) versus 0.26 for the Singapore stock market. This means that investors are better off with 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. For example, in 2015, the Danish stock market was the number one equity performer with a return of around 23 per cent. Investors who then piled into Denmark following its stellar performance ended up being bitterly disappointed as the Danish stock market subsequently lost 16 per cent the following year.

Investing steadfastly in global stocks during this same period would have netted investors a range between minus 2 per cent and 8.5 per cent. Investors with a global portfolio would have experienced reduced volatility and higher returns at the end of the two years.

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. This point cannot be emphasised enough, and although it sounds mundane and rudimentary, many people still end up holding the wrong type of assets, in the wrong type of mix, only to suffer big losses when they sell in panic at the wrong time.

Most financial advisers and relationship managers either do not spend enough time talking about risk with their clients or are themselves oblivious to risk. Ask your adviser or relationship manager about the risk of a fund or portfolio, and many will merely quote its volatility figure. In fact, a metric known as the Value-at-Risk (or VaR) is a better measurement of risk investment than volatility, 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 would typically have a one-year Value-at-Risk of 18 per cent. For instance, the potential loss on a $100,000 investment is likely to be capped at $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 Value-at-Risk is around 10 per cent. This would indicate a potential loss on a $100,000 investment of $10,000.

Using this method of risk evaluation, the investor can thus assess his or her level of comfort with the magnitude of potential loss, before deciding on the investment.

Going back to our car analogy then, if you have ever driven long distances overseas, you will know that road conditions can swiftly change from benign to hazardous 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, and as it concerns your hard-earned money, it is even more 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, they do help to smoothen out the more serious bumps, and help you stay invested to reap the long-term returns.

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(This is part of a series of articles that we have been writing for Singaporean investors.)