Why diversify?

User Written by Jamie Bubb-Sacklyn on August 07, 2018.

Why diversify?

Last month I made my Malaysian radio debut on BFM’s Ringgit and Sense programme talking to Tan Chung Han about the importance of diversifying an investment portfolio. Diversification is all about reducing risk and is a cornerstone piece of advice that I give to my clients.

Firstly, we talked about investing globally rather than locally. This is something which Malaysian clients in particular are often reluctant to do. While it is understandable that many investors have a home bias, tending towards markets which they are more familiar with, spreading investments over different geographical areas can reduce overall portfolio risk. For example, if a particular region is having a tough time with a falling market, this can be compensated for by investing in assets in other parts of the world where they are not correlated with the falling market and are, in fact, rising. In recent times we’ve seen emerging markets suffer due to trade wars but investors with assets in the US, will not have been so adversely affected.

We talked about the benefits of active management which can be an important weapon in times of normalised volatility, something which has been particularly relevant this year. Active managers, fees notwithstanding, will look at macro-economic indicators and adjust funds accordingly. Another example from earlier this year was geopolitical indicators causing active fund managers to move funds out of Italy, whereby the passive funds remained and encountered losses.

That said, investors should be wise to avoid knee-jerk reactions to headlines. I gave the example of a client who sold his entire pension portfolio after suffering a near 10% fall in the days following the Brexit referendum back in 2016. Unfortunately for him, the markets recovered quickly and his time out of the market cost him dearly. A lesson to be learned on ignoring ‘noise’ in the media and keeping focused on long term goals that you have in mind. I’m a firm believer of time in the market being more important than timing of the market. Those who try to time the market on a regular basis rarely get it right and end up worse off in the long run. Usually the best way to deal with volatility is to simply ride it out. Sometimes it even provides opportunities.

Another way of diversifying is by investing across different asset classes. That means not just investing in equities but also bonds, absolute return, commodities, property and cash. When it comes to property, Malaysians, like Brits, seem to prefer tangible assets even if they are at the mercy of occupancy rates, stamp duty and agency fees. Many people overlook the benefits of a collective property fund or a Real Estate Investment Trust which is naturally more diversified than a single property holding. An investment of this type not only reduces tenancy and liquidity but also saves your time, effort and resources. Not to mention that collective funds also increase the options for those who do not have sufficient initial capital to put down a deposit on an individual property.

A diversified portfolio will also include bonds. Key considerations when deciding where to invest in bonds are yield, duration and whether to invest in government-backed securities which are naturally more secure than corporate bonds or emerging market debt. The key is to find a fixed income return that will pay you more than your bank account offers you in interest. In recent months we’ve seen US treasuries, for example, with yields of between 2.5 and 3%.

I gave an example to demonstrate how diversification can protect your portfolio based on the volatility of both emerging markets and bonds in the two years following the financial crisis in 2008. In 2008 emerging market equities plummeted delivering a negative return to the tune of 35% while bonds and fixed interest investments gained 12% in the same year. The following year however, emerging markets rebounded strongly with a 59% increase compared to just 1% for bonds. Those investors diversified across these two asset classes over both years would have benefitted from smoother returns in what were a bumpy couple of years for all involved.

For those wishing to invest overseas I would highly recommend working with location-based fund managers who will have a greater knowledge and understanding of their local markets. Focus on choosing a competent fund manager rather than looking at the performance of individual stocks. At Infinity, we work with the Tilney Group who have a huge amount of expertise and can do all the hard work for you. You will achieve natural diversification by investing in collective funds rather than individual stocks.

Currency fluctuations can also play havoc with portfolios. Imagine Malaysian stocks rise 20% but the ringgit falls 20% vs the dollar – are you in a better overall position? A steadier return is normally achieved by investing in less volatile currencies, namely the US dollar, Sterling or Euro.

We touched on the issue of trade wars which are of particular relevance right now as Trump’s tariffs punish exporting markets. The US may well benefit the most initially from these tariffs which is likely to prolong the current bull market we are seeing. Trade wars are just one of many other reasons to have a fully globalised portfolio and protect your investments.

In summary, I am a strong believer in modern portfolio theory (MPT), which is as relevant today as it was when it was published back in 1952. Essentially, MPT states that given 2 portfolios with identical returns, an investor would choose the portfolio that has taken the least amount of risk to achieve that return. By diversifying geographically and by asset class, investors should achieve just this which leads to smoother returns over time.

If you would like to hear our chat in full, you can listen to the podcast here. If you’d like to discuss the content covered further or have any questions, feel free to get in touch with me at Jamie@infinitysolutions.com.

Jamie Bubb-Sacklyn

Jamie Bubb-Sacklyn

Posted on August 07, 2018 in Investments.