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Sunday, July 19, 2015

Diversification: Will it make you rich?

Dr Larry Haverkamp
July 2015

The first rule of investing is to diversify.

Why is that so important? It's because if you own a few investments, you will reduce risk without reducing returns. This is valuable, costs nothing and is what economists call "a free lunch".

If you have risky investments, like stocks or property, the best way to reduce the risks is to buy bonds. It works like this: When the economy is strong, stocks do well and interest rates rise. Because of a peculiarity of bonds (that the coupon is fixed), higher interest rates make bond prices fall.

Did you catch it? When stock prices go up, bond prices go down. Academics call it "negative covariance" and it is very good for diversification as it reduces a portfolio's volatility. Better still, it reduces risks without reducing returns. Nothing but bonds have such a large negative covariance, which makes them very special.

The drawback is bonds are a low-risk investment, so it is hard to get this excellent risk-reducing feature without opting for low risks and returns. Suppose that isn't what you want? You might want high risks and returns. Sorry, then you are out of luck. When you buy bonds, you get the good with the "possibly not-so-good" and  there is no way around it.

Except for one thing. You can also diversify over time by staggering your buying or selling.

Bill Gates does this. He sells a fixed per cent of his Microsoft stock every quarter and has been doing it for the past decade. His buddy Warren Buffett does the same. Warren gives away five per cent of his wealth every year, and incidentally, he gives it to the Bill and Melinda Gates foundation since he judges Bill Gates to be the best in philanthropy.

You can do it too. Just invest continuously in equal-sized investments. Of course, you will get even more risk reduction if you also buy bonds but it may push you into a lower risk-return category than you want. If it does, time diversification is the best you can do, but it's good enough as it smooths the ups and downs that occur over time.

The next big question is should you do it yourself (DIY) by buying shares in the market? Or should you purchase a fund, which gives instant diversification?

Professionals typically advise buying a fund. But many of these pros have a vested interest since the fund pays them a commission. Is this a conflict of interest? Ha, ha, ha. That's a good one!

If you go the fund route, you have three choices: An investment-linked product (ILP), a unit trust or an exchange-traded fund (ETF). Of these, I recommend the ETF. It is almost sure to be "passively managed", which means it is an "index fund". This is the opposite from an "actively managed fund", which is what we have for 95 per cent of the ILPs and unit trusts sold in Singapore.

The problem is the costs (yearly expense ratios) of actively managed funds are always higher than passively managed ones. The higher expenses are probably not justified since the average returns of these funds are not higher.

But wait. Instead of investing in the average fund, why not go for the best? Buy a "top 10 per cent fund"! The only thing wrong with that is the top 10 per cent are not "persistent", which means each year sees a different group of funds in the top 10 per cent.

Of course, fund managers don't like these findings and rarely bring them up when advising clients. Adding to the conspiracy of silence is that ETFs don't advertise (to keep expenses low) while actively managed funds do. That's why you don't see these results in newspaper ads, on the MRT train or anywhere else.

It all points to ETFs being a far better choice than actively managed funds.

There is a third choice, which is DIY. It means you choose which stocks to buy. But is this a good idea since you don't have expertise in stock picking?

Yes. It is a good idea. That's because expertise doesn't matter in this game. Recall that actively managed funds, with lots of high-priced "experts" do not out-perform index funds and the reason is all information available to experts is already included in the stock price. The experts will out-perform only if they have special or insider information, which is rare and even if they have it, it is probably illegal to use.

Finally, is DIY better than an ETF? I think so. First, you can have more fun with DIY since you can pick 15 or more shares to eliminate volatility and you'll probably achieve average returns, just like an ETF. But who knows? You may be a great stock picker. So play around, have some fun and it won't cost much. Online brokerage costs are only 0.6 per cent for a round trip (buy and sell) for both DIY and ETFs.

The second cost is yearly expenses and it is true these are super low for ETFs. But they are not zero. For DIY, however, they are zero. You buy shares and there is no charge for holding them.

In comparison. unit trusts and ILPs are much more expensive for both annual expenses and initial commissions. An adjunct professor at SMU, Dr Haverkamp contributes this column weekly to help our readers understand money matters better.

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