Don’t put all your eggs in one basket: Diversify Investments, Diversify Risks
Even if you are new to investing, you may already know some of the most fundamental principles of sound investing. How did you learn them?
by Stanley Wu
Even if you are new to investing, you may already know some of the most fundamental principles of sound investing. How did you learn them? Through ordinary, real-life experiences that have nothing to do with the stock market.
For example, have you ever noticed that street vendors often sell seemingly unrelated products — such as umbrellas and sunglasses? Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never — and that’s the point. Street vendors know that when it’s raining, it’s easier to sell umbrellas but harder to sell sunglasses. And when it’s sunny, the reverse is true. By selling both items- in other words, by diversifying the product line — the vendor can reduce the risk of losing money on any given day.
Diversification
Diversify your investments. That is the mantra that is so often repeated that it is almost meaningless among the general investing public. In this article, I hope to show you some of the subtleties regarding diversification and perhaps leave you with a big picture understanding of diversification, correlation and how to diversify.
Before we start on diversification proper, let me first ask what do you hope to achieve by investing. For most of us, it is so that we will be rewarded with returns. One could say we wish to maximize returns. Of course, the savvier investors would point out that in actuality, we wish to maximize the returns while minimizing the risks to a level that we are comfortable with. The second part is crucial as otherwise, we would bet all our money on something extremely risky in pursuit of high returns and possibly losing a substantial portion of the principal as a consequence.
How does diversification come into play in investing? Well, for any investment that you hold, you can think of the returns from this investment as being the sum of the market return and specific return. What does it mean? Market returns are simply returns compensating the investor for bearing market or systematic risk. So if the market goes up, the market return will follow. Specific return pertains to the return that is specific to this asset. You can sort think of market returns as the sea level that raises all assets and the specific return as individual waves on top of the sea level that introduces an element of choppiness to the overall return of that particular asset. If you have a small concentrated portfolio (you can think of it as a small boat), the granularity of the waves can really drive up or down the boat. Whereas with a large diversified portfolio (think of it as a large boat), the exposure to multiple “waves” will generally cancel each other out with the net effect that the overall centre of the boat will be closer to the average sea level. This presupposes the waves are “uncorrelated”. Imagine that the crests of the waves are exactly spaced apart to push up the boat in a concerted way. Clearly, this will drive the boat well above the average sea level. So for us to get a smooth calm ride, we really need the waves to be rather random so that the wave acting on one part of the boat is cancelled by another corresponding one. Perhaps this is not the best analogy but hopefully you get the big picture.
Investment portfolio and correlations
The above discussion is all fine and good but how does this apply to the ordinary investor? Let us say you are an ordinary investor whose portfolio consists of primarily Citigroup (ticker: C), Exxon-Mobil (XOM), IBM and Walmart (WMT) stocks. These blue-chip companies belong to the financial, oil, technology and retail sectors respectively. At first glance, it certainly does look like a pretty well-diversified portfolio. Let us turn our attention towards the correlation of these stocks. From January 1, 2013 till April 1, 2014, the following correlation table can be calculated.
A correlation of 1 means that the cross-assets are perfectly correlated or in other words, move in the same direction in a synchronized fashion. A correlation of -1 is when the movements are synchronized as well but in opposite directions. To maximize the benefits of diversification, one should aim to have assets that are not correlated , i.e. around 0. In my experience, a correlation level of 0.3 is not ideal but still acceptable from a diversification perspective. When it hits around 0.7, then the assets tend to move together a lot more than we want. Think of it this way. If Citi and IBM have a correlation of 0.38 and IBM and WMT have a correlation of 0.34, there is actually not much we can say about the correlation between WMT and Citi. That’s because there is so much freedom for these assets to move individually. But if Citi and IBM have a correlation of 0.9 and IBM and WMT have a correlation of 0.9, then surely Citi and WMT must have a high correlation as well. That’s because if Citigroup and IBM have to move in sync most of the time and the same is true of IBM and WMT, then Citigroup and WMT must be mostly in sync too. To use a literary analogy, highly correlated assets could be thought of financial equivalent of Tolstoy’s “happy families”; they are alike.
For the same group of assets above, let us look at the correlation table for September 2008 (the month that Lehman Brothers declared bankruptcy and triggered global financial chaos).
We see that all the correlations between the assets have skyrocketed. And if you look at the actual asset price movements in that month, the above numbers do reflect the observation that the assets were plunging in sync with each other.
You might be worried that I am cherry picking the evidence to back my case. So below, I have plotted a graph of the rolling 1-month correlation of the individual assets against the market index (S&P 500 in this case) from April 2008 to March 2009.
We see that Citibank is highly correlated with the overall market index across the entire year, which is not that surprising as the financial sector is one of the mainstays of the market index. IBM is highly correlated most of the time. Walmart and Exxon-Mobil less so. Looking at the situation in April-June 2008, one might be forgiven for thinking this is a pretty well diversified portfolio. However, from September-November 2008, the correlations shoot up and all the assets move in sync. The ordinary investor who holds this portfolio would be subjected to a psychologically trying time. Does he exit the market now and realize his extensive losses? Or does he stay in the game and suffer through the emotional rollercoaster ride of holding this portfolio through September-November 2008 and perhaps having to wait years for it to recover? He might ask where did he go wrong? Well, there have been many studies of financial crises and one thing that crops up over and over again is that correlations typically increase during financial crises. Just when you need the benefits of diversification the most, your portfolio lets you down. In the next section, we will consider what an ordinary investor might do to protect himself.
Defensive measures
Given all that we have seen in the previous section, what is an ordinary investor to do? I would say much depends on the individual investor. If your net worth is substantial enough and capital preservation ranks high in your list of investment objectives, I would recommend that you look into bonds and real estate as possible investments, of course doing your due diligence. For the rest of us, the returns from bonds (at least the non-junk graded ones) might not satisfy our investment objectives and real estate can be hard to liquidate in a bearish market. Furthermore, an all-time fully diversified investment portfolio is not always the best way to achieve your investment objectives. There are plenty of occasions when it is useful to concentrate your investments in particular sectors or stocks. In my opinion, it is only when one is adopting a long-term buy-and-hold strategy that it makes sense to have a fully-diversified investment portfolio at all times. Notice the caveat fully diversified at all times. For most of the time, it is perfectly reasonable to want only some degree of diversification.
What would be a good way of achieving it? I am going to recommend exchange traded funds (ETFs). These are usually a basket of assets from a particular sector or industry or even geographical location. It has lower fees (some of them are as low as 0.04% per annum) than mutual funds and trades like a stock on the exchange. These days, you can find ETFs on nearly anything: bonds, real estate, biotech sector, commodities, etc. There are a few things you need to be careful about:
- Liquidity. Check the average trading volume and the difference between bid and ask price. If the former is too low (less than a million) and the latter is too wide (greater than USD 0.03), stay away from it as you might have issues trying to transact in future. This obviously rules out quite a few commodity ETFs but ultimately the decision rests with the investors.
- Management expense ratio (MER). This is the fee the fund managers charge investors for managing the ETF. A high MER would of course eat into your investment returns.
- Strategy. By all means, read the prospectus. Unless you know what the ETF is doing, do stay away from leveraged ETFs that exhibit highly volatile returns.
This concludes my short article on diversification and hopefully you’ve been able to take away some useful tips. Knowing what could go wrong would put you in a much better position when the markets do unravel again.
Originally published at ignition.co.
