Published: 7:51 AM, April 24, 2016
Some investors figure that buying shares in just one company or only a few is the way to make the most money, since they’ll earn more if those few go up a lot. Shares can go down too, however, so they could just as easily lose big if the share prices plummet. A far better strategy, which balances risk and reward, is diversification.
Diversification refers to investing in different categories of investments, such as shares and bonds and real estate and commodities, rather than just one category. Within each category, diversification also means investing in shares or bonds from many companies rather than just a few.
The reason for diversification, as investment research firm Morningstar explains it, is that investors can improve their risk-return profile by investing in multiple investments rather than concentrating in a single one. Holding a single stock rather than a perfectly diversified portfolio increases annual volatility by roughly 30 per cent, according to the American Association of Independent Investors (AAII). A single-stock investor has a portfolio volatility of about 45 per cent, AAII found, which is far higher than the average market volatility of about 15 per cent.
Research in Singapore as well as other markets has indeed shown that diversification results in a better risk-reward ratio, because different categories of investments have historically tended to move in different directions. UBS here said that spreading your funds among a basket of different assets – whether it’s cash, bonds, hedge funds, or public and private equities - that are not correlated to each other is an effective way to minimise risk, and research shows this diversification accounts for just over half an investor’s return. Looking at the US, Morningstar similarly said that as stocks have soared over the past five years, long-term government bonds have reliably gone in the opposite direction.
Even investors as big as the GIC here use diversification. GIC says it manages “a well-diversified portfolio to produce sustained, superior risk-adjusted performance.”
While a diversified investment portfolio will likely not have as high returns as shares in one company that soar, neither is it as likely to have the volatility and the losses of shares that plummet. Investors benefit from diversification, then, because it improves the predictability of investment returns and ensures a better balance between the risks of any one company and the rewards of investing in a multitude of firms.
HOW TO DIVERSIFY
After deciding to diversify, the next step for investors is to decide how to do it and move forward.
As investment management firm Vanguard Singapore noted, investors should start by setting measurable investment goals and developing plans for reaching those targets. The plans will likely include the length of time to hold the investment, the objectives to achieve, and what types of investments to make. With that plan in hand, there are several ways to diversify your investment portfolio to optimise your returns.
One is to select a multitude of individual shares, bonds and other investments by yourself.
While early research in the 1960s by J. Evans and S. Archer showed that holding shares in 15-20 companies might be sufficient, more recent research has shown that holding shares in at least 30 or more companies can result in better returns. For bonds, investment management firm PIMCO similarly said that maintaining a diversified bond portfolio can help investors prepare for shifts in the economy and interest rates, allowing them to capture opportunities while minimising the risks of overconcentration. Bonds can be diversified by, for example, maturity or quality or geography. You could select shares and bonds from dozens of companies, then, to achieve diversification.
An alternative is to select different unit trusts or exchange-traded funds (ETFs) that hold shares or bonds from many different companies, as well as ETFs that hold real estate or commodities such as gold. Along with investing in ETFs such as the Singapore STI ETF and the ABF Singapore Bond Index Fund to gain diversification in Singapore, investors can select other ETFs that hold international shares or international bonds.
While diversification is indeed essential for optimising the balance between risk and return, it is also important not to over-diversify. As investment advisory firm Motley Fool in Singapore noted, an overly diversified portfolio can result in an investor merely matching the market’s return. “That’s not necessarily a bad thing, but it could be detrimental if the investor’s aim is to earn market-beating returns. At the same time however, it is important that we bear in mind how crucial diversification can be.”
DIVERSIFICATION IS FOR EVERYONE
As Santa Clara University Professor of Finance Meir Statman said: “People who hold undiversified portfolios, like people who buy lottery tickets, behave as gamblers since they accept higher risk without compensation in the form of higher expected returns.” Investors can do far better by creating a diversified portfolio with various categories of investments so that they optimise the balance between risk and return.