Written by Ang Kok Heng
Monday, 22 June 2009 11:03
It is common to hear the advice “Don’t put all the eggs in one basket.”
Diversification is always a prudent way to reduce risk. There is no certainty in investments. As long as risks exist, it is always necessary to diversify. Sometimes the risk is obvious to us but in many cases, the risk springs up unexpectedly. We can also be misled by the past experience to assume that everything should be okay until something happens, as there is always unforeseen circumstances. There are inherent risks in most investments. Even if they do not pose a problem in the past, there is no assurance that they will not come out to haunt us in the future.
Degree of diversification
The degree of diversification to minimise risk is very subjective. It depends on the need of an individual as well as the circumstances at a particular point in time. In most cases, if a particular risk is assumed to be low, the need to diversify from the risk is generally low until something happens. Liquidity risk which has been ignored in many financial assets, caused many institutions to suffer huge losses last year.
General portfolio mix
Most people will have some form of savings. As the wealth level increases, there are more ways and more needs to diversify.
The simplest form of investment is savings in fixed deposits. For those who are risk-averse, it may be prudent to spread the risk by placing deposits with more than one bank. It is also common nowadays for most Malaysians to have some investments in one or several unit trust funds. For those who are more adventurous or more knowledgeable, they may even open accounts with local stockbrokers for the purpose of share investment.
With the convenience of bank financing, it is also not uncommon for many salaried staff, after working for several years, to own a house with the help of bank financing. Unknown to many, there are several major risks of investing in a property. For the purchase of a new house via a developer, there is the project incompletion risk. If the loan is BLR plus/minus (which is the case in most housing loans) certain percentage points, there is an inherent interest rate risk if the rate escalates. Not to mention every property has inherent location risk.
For the more wealthy, a wider diversification will include foreign currency investment, purchase of structured products issued by banks and investment in gold products.
More stocks less risk
For those investing in stocks and shares, a single stock portfolio is definitely higher risk. The return could be high if the particular stock happens to yield a good return. As there is no absolute certainty that the future will be as good as the past, it is always prudent to have a portfolio with several stocks.
Many Hongkongers invested their life savings in HSBC, the bluest of the blue chips in Hong Kong, believing that this will be their best retirement savings. They were not wrong until the recent financial crisis, causing HSBC’s share price to plummet from a high of HK$160 (RM73.03) to a low of HK$30 before recovering to HK$67 after the rights issue. Of course there were many similar instances where staunch supporters continue to invest heavily in a blue chip which they strongly have faith in. Many insurance agents of AIG, once the world largest insurer, have also invested regularly in the stock in US over the years before the stock plunged from US$103 (RM363.59) to below US$1 at the trough of the financial crisis in March this year.
There were many research papers conducted by various people in many parts of the world to determine how many stocks should a portfolio have to optimise risk. Surprisingly, the results were the same. Almost all of those research papers concluded that the optimum number of stock to reduce a portfolio risk is about 25 stocks.
Sector diversification
Having said that, a portfolio of 25 stocks concentrated in a particular sector say property and construction sector is not a good diversification strategy. In the event of a downturn of the property and construction industry, most of the stocks in the sector will fall together. The recommended optimum 25-stock portfolio assumes that the 25 stocks are chosen at random and they are from the various sectors such as industrial, finance, plantation, hotel, infrastructure, trading services, etc.
As such, it is important for investors to understand that a well-diversified portfolio does not end at just 25 stocks, it must also have sufficient diversification among the 25 stocks. If a stock has several businesses such as Sime Darby (plantation, housing development, motor vehicles distribution, trading, manufacturing, etc), Multi-Purpose (gaming, property investment, stockbroking) and YTL Corporation (power producer, water management, construction, hotel, property development, REIT, etc), they are more diversified than single-business stocks such as Carlsberg (liquor), Kuantan Flour Mill (flour milling), Mah Sing (property development), Unisem (semiconductor contracting), Top Glove (examination glove producer), Tenaga Nasional (power generator and distributor) and DiGi (mobile service provider).
For investors who do not want to monitor too many stocks, the way to achieve the required diversification is to incorporate more conglomerates into the portfolio after having taken into consideration of the different businesses of the conglomerates.
Size diversification
Other than diversification according to business sector, investors should also take note of size diversification, though it is less important. A portfolio, which has invested in the various business sectors possibly allowed, may not be adequately diversified if all the stocks are mid- to small-cap stocks. This type of portfolio is akin to a small-cap unit trust fund which is quite volatile both in an up and down market due to the lower liquidity of the stocks concerned. As such, a well-balanced portfolio should not be biased towards a particular segment.
Other than size, there are also other segments that appear in our market. Some of which are high and low beta stocks, politically-linked and non-politically-linked stocks, family-owned versus institution-owned stocks, foreign MNC-owned and government-linked stocks, family-managed versus professional-managed companies. From time to time, there are obvious trends in these segments too.
Style diversification
As everyone has his own investment style, an investor who manages his own fund has only one style of investment which is linked to his character. The various investment styles include preference to invest in value stocks or growth stocks, inclination towards investment or speculation, tendency to buy-and-hold or trade, short-term bias or long-term bias, favour low beta low-risk stocks or high beta high-risk stocks etc.
As investment style is related to the manager of a fund, an individual who manages his or her own fund will not enjoy style diversification. Since different phases of a market requires different style of investment, an investor will only perform well during certain period of a market. The same applies to professional fund manager who will have his own style. Very rare can we find a fund manager who is able to change his or her style according to the behaviour of a market — eg from conservative to aggressive, from small-cap preference to boring blue chips, from strategic sector allocation to tactical stock pick, etc.
Investors who invest via unit trust funds may benefit from style diversification through investing in funds of various fund houses instead of putting all of the money in just one fund house. This type of diversification is possible provided the different styles of different fund houses are known. Investors can get some cues of the manager’s style by looking at the different portfolio turnover ratios (low for passive manager and high for active fund manager) and the different type of stocks held in a portfolio.
Time diversification
Many neglected time diversification. It is not uncommon, especially during buoyant times, to see an investor with RM50,000, looking at what to invest. When the investment loses money, the investor will blame everybody including the financial planners and the fund managers except himself. This type of “bullet investment” could turn sour if the timing is wrong. There is no assurance when one enters the market, it will not turn downhill immediately. Time diversification requires the investor to spread out the investment over time, instead of putting all the money in one go to avoid entering the market at the wrong part of the cycle.
Country diversification
Having invested in Malaysian stocks alone may not be sufficient for some investors who have the means to diversify further. For example, the recent market recovery from the mid-March low, the KLCI rebounded less than 30%, whereas neighbouring bourses such as Singapore’s Straits Times Index and Hong Kong’s Hang Seng Index surged about 60%.
Diversification outside of Malaysia allows currency diversification (normally no hedging is required) as well as more varieties of stocks which may not be available on Bursa Malaysia. Obvious examples supporting regional diversification are mining stocks in Australia, tech stocks in Taiwan, hotel stocks in Hong Kong, etc.
Country diversification is useful as not all countries perform equally well due to the different political and economic situations. If possible, the country chosen should be quite different from Malaysia’s character. Examples are developed economies in Europe; commodity-driven countries like Australia, Canada and Brazil; oil-rich countries in Middle East; largely populated nations of China and India; tech-heavy bourses in Taiwan and Korea; emerging markets in Eastern Europe, etc. This type of diversification can be achieved by investing in unit trust funds or country ETFs (exchange traded funds).
Product diversification
So far we are discussing about investment in stocks and equity-related instruments. A more diversified portfolio should have more than that. A well-accepted diversification internationally, is a 50/50 mix between equity and bond, which behaves quite differently, and hence has low correlation with stocks.
Many Malaysians who have invested in property have benefited from the fairly stable property prices. Property as an asset class in Malaysia, be it residential or commercial, enhances the overall portfolio stability.
Other than stocks, unit trusts, bonds and properties are good combination in a diversified portfolio. Other asset classes suitable for diversification purposes include commodities, gold, private equities, alternative investment and hedge funds.
Correlation diversification
Assuming there is a simple portfolio P of only two asset classes A and B, which could be two stocks or equity and property. The risk of portfolio, p, is the result of risks of the two assets (A , B), the proportions invested in the assets (WA and WB such that WA + WB = 1.0) and the correlation between A and B (AB). The risk of the portfolio is determined by the formula:
p² = WA²A² + WB²B² + 2WAAWBB AB
Every investment has an expected return ( R ), and risk ( ) as defined by the standard deviation of return. If we can find another asset giving the same return but may behave differently, then it makes sense to spread our portfolio investment in the two assets instead of betting on one asset class only.
The resultant portfolio return will be the same, but the portfolio risk ( p ) will be lower if they are not correlated ie AB < ab =" 0.">