Starter guide to portfolio diversification

It is wis­dom well known to house­wives through the ages — and investors will do well to heed it. Putting all your eggs in one bas­ket is almost always folly and this is no dif­fer­ent where invest­ments are concerned.

Port­fo­lio diver­si­fi­ca­tion is widely recog­nised as a vital tech­nique for reduc­ing risks that are part and par­cel of invest­ing. Indeed, it is prob­a­bly the most impor­tant ingre­di­ent for reach­ing one’s long-term finan­cial goals while keep­ing risk to a min­i­mum. Finan­cial mar­kets are noto­ri­ously known for their vul­ner­a­bil­ity to swings but it is these very cycles that present prof­itable invest­ment oppor­tu­ni­ties. Yet even the savvi­est investors are hard-pressed to pre­dict these crests and val­leys accu­rately all the time, much less pick win­ners and losers with absolute precision.

Max­imise profit, min­imise risk

Diver­si­fi­ca­tion recog­nises this lim­i­ta­tion in our div­ina­tion abil­i­ties and presents a real­is­tic and prac­ti­cal approach to help the investor max­imise his or her returns.

The basic con­cept is sim­ple: Spread your money across a vari­ety of finan­cial instru­ments, indus­tries and geo­gra­phies, so that when a mar­ket shock occurs, you do not risk los­ing your entire wealth in one fell swoop. The reverse is also true: When mar­kets are boom­ing, cast­ing your net wide increases the chance of own­ing the winners.

Under­ly­ing diver­si­fi­ca­tion is the fact that dif­fer­ent assets do not react iden­ti­cally to a sin­gle event. For an investor, it is impor­tant that in any part of the mar­ket cycle, some assets do well so as to off­set the weak per­for­mance of oth­ers. As an exam­ple, dur­ing the recent finan­cial cri­sis, while most finan­cial assets fell, gold defied grav­ity and proved a big win­ner for many investors.

More is not always bet­ter — watch for cor­re­la­tion risk

There are many ways of achiev­ing diver­si­fi­ca­tion. For many, a diver­si­fied port­fo­lio means own­ing a vari­ety of stocks in dif­fer­ent indus­tries, geo­gra­phies and cur­ren­cies. But supe­rior diver­si­fi­ca­tion is often achieved through spread­ing your invest­ments across dif­fer­ent asset classes as well.

The under­ly­ing aim is to own a com­bi­na­tion of invest­ments which are as uncor­re­lated with each other as pos­si­ble. Sim­ply own­ing a large num­ber of dif­fer­ent invest­ments may not achieve the aims of diver­si­fi­ca­tion if the assets react largely in a sim­i­lar man­ner to adverse events.

For exam­ple, if your port­fo­lio con­sisted only of prop­erty equi­ties, cool­ing mea­sures by the gov­ern­ment may cause the port­fo­lio to drop in value. This could be mit­i­gated if you also owned bank stocks. How­ever, these too may be hit by the cool­ing mea­sures as damp­ened demand for mort­gages weak­ens bank lend­ing busi­ness. To fur­ther diver­sify, you may want to include stocks in less related sec­tors such as man­u­fac­tur­ing and technology.

Bet­ter yet, diver­si­fy­ing into another asset class, such as bonds, can fur­ther mit­i­gate your portfolio’s sen­si­tiv­ity to mar­ket swings. Bonds and stocks, for instance, gen­er­ally move in oppo­site direc­tions. If your invest­ments are bal­anced across both asset types, neg­a­tive move­ments in one may be off­set by pos­i­tive results in the other.

Indeed, stud­ies have shown that asset class choice mat­ter more than indi­vid­ual secu­rity selec­tion — about 70 per cent of a portfolio’s per­for­mance is derived from get­ting into the right asset class at the right time.

One size does not fit all — and not all the time

So how then should you deter­mine the opti­mal blend of invest­ments in your portfolio?

Tak­ing a long-term view, first work out what your finan­cial aims are, con­sid­er­ing the time hori­zon and the level of risk and volatil­ity that you are com­fort­able with.

By and large, a young investor may pre­fer a more aggres­sive port­fo­lio that bears more risk as com­pared with a retiree who is more con­cerned about wealth preser­va­tion and main­tain­ing a steady income.

Mar­ket cir­cum­stances must also be con­sid­ered and as they change, so must your port­fo­lio be reviewed and rebal­anced. Con­sider engag­ing expert help from bankers and finan­cial advis­ers, who, with access to more tools and up-to-date mar­ket infor­ma­tion, can help you with a peri­odic review of the per­for­mance of your port­fo­lio and make appro­pri­ate adjust­ments in asset allo­ca­tions with a view to meet­ing your invest­ment objectives.

This exer­cise is vital as changes in the mar­ket as well as indi­vid­ual cir­cum­stances can impact the out­look of your port­fo­lio. Wealth man­agers have a for­malised process to pro­vide this ser­vice as part of their advi­sory offering.

One con­ve­nient way to achieve a diver­si­fied port­fo­lio is to invest via unit trusts. Each fund is diver­si­fied across a mul­ti­tude of secu­ri­ties within the fund’s invest­ment theme. Some even offer expo­sure to dif­fer­ent asset classes, such as a com­bi­na­tion of stocks and bonds. For more sophis­ti­cated investors, spe­cialised instru­ments such as hedge funds and exchange-traded funds, offer addi­tional ways to diver­sify their investments.

As with diets and many things in life, bal­ance is nec­es­sary for the health and longevity of your invest­ment port­fo­lio. Regard­less of how attrac­tive that “sure win” invest­ment looks, too much of a good thing can turn a port­fo­lio bad quite quickly. Instead, take advan­tage of the vari­ety in the buf­fet of global assets and put together a plate that best suits your finan­cial goals and risk appetite.

Shrikant Bhat is head of wealth man­age­ment at Citibank Sin­ga­pore Limited.