Diversification boosts returns, cuts risk
By: Herbert Lian
SINGAPORE (Jan 19): Ask any Singaporean on the street about his first significant investment and, chances are, the answer will be, “Buy property, lor!” Fine, you say. How about after that? “Buy second property. Singapore so small, property won’t go down one.” Third choice? “Buy blue chips, sure safe and got dividends.”
This article is not about the relative merits of investing in property versus equities; that subject has been well covered by many and the general agreement is there are advantages and disadvantages to both. It is enough to note that despite what many Singaporeans believe, property is not always the highest-return and safest asset class to invest in. Just ask anyone who bought property at the peak of the market in 1996.
Instead, this article is about the value of spreading one’s investments beyond property into two asset classes — equities and bonds. Property is illiquid and, for most investors, each purchase represents a highly concentrated bet. If interest rates spike or cash flow becomes an issue, one could be forced to sell the property at a disadvantageous time, leading to hefty losses. For these reasons, even if leveraged property was clearly the highest-yielding asset class (which is not always true), it would be imprudent to put all of one’s investible wealth there.
Therefore, it makes sense to hold a significant portion of your portfolio in other, more liquid assets such as local stocks and bonds (either directly as debt or through bond funds). There are many who would invest in one or the other; in particular, for those with a long time horizon to ride out volatility, it seems counter intuitive to dilute your equity returns with the lower returns associated with bonds. Nevertheless, I believe almost everyone would benefit from having a Diversification boosts returns, cuts risk mix of both in their portfolio.
Also, holding both stocks and bonds can often lead to higher returns and ensure that part of the portfolio can be converted to cash for emergency use at any time, without taking a massive loss owing to temporary market conditions. In particular, bonds are much less volatile than stocks, and the safest bonds tend to be negatively correlated with equities (that is, they tend to move in opposite directions). This maintains a pool of funds to draw down if necessary, even when equity prices are depressed.
For example, during the 2008 financial crisis, many Singaporeans lost their jobs and had trouble servicing their mortgages. Singapore equities, as measured by the MSCI Singapore stock index, lost 47% of their value that year. In contrast, the iBoxx ABF Singapore bond index, which measures a diversified basket of Singapore denominated bonds, returned 7% in the same year. At that time, bonds would have been a much better source of emergency cash flow compared with liquidating depressed equity positions.
Another reason for holding both stocks and bonds is that that can often lead to higher returns and a more stable portfolio value than holding stocks alone. For example, in Chart 1, we see that the MSCI Singapore stock index returned 5% per year from 2000 to 2015 while the iBoxx
ABF Singapore bond index returned 3.3%. But a 70% stock/30% bond mix, rebalanced yearly, would have had higher returns than either, and with less violent fluctuations compared with a 100% stock allocation.
In fact, we can compare the effect of holding different proportions of stocks and bonds over the last 15 years. In Chart 2, the vertical axis measures investment returns, while the horizontal axis measures volatility (the technical term for how violently the value of an investment fluctuates). We see that a 100% stock allocation has 5% returns and very high volatility, while a 100% bond allocation has 3.3% returns and low volatility, consistent with Chart 1.
What may be surprising to some is that a mix of stocks and bonds outperforms both of these allocations in terms of returns and volatility. Introducing a small bond allocation into a 100% stock portfolio drastically reduces volatility, while improving returns. Over the last 15 years, a 70%/30% stockbond mix gave higher returns than an all-stock portfolio, with two-thirds of the volatility — something we have already seen in Chart 1.
More interestingly, even those who prioritise stability of value might be well served by holding a small stock component in their portfolios. Because stocks and bonds tend to move in opposite directions, changing the stock-bond mix from 0%/100% to 10%/90% actually reduces volatility and increases returns from 3.3% to 3.9%, a significant jump. A 30% stock allocation would increase returns to 4.75% — quite close to an all-stock portfolio — for only a small increase in volatility from an all-bond portfolio.
How about that for the best of both worlds? Such is the power of diversifying into uncorrelated or negatively correlated asset classes.
In fact, it is possible to further diversify into international stocks and bonds to reduce exposure to Singapore’s economic performance. Alternative investments such as private equity or hedge funds can also deliver diversification with uncorrelated returns. These will be discussed in future articles.
However, even if you were to stick only to local investment opportunities, do consider going beyond property into a mix of stocks and bonds, and doing so as soon as possible. Too many young professionals buy an expensive property, move into their dream house and then spend decades servicing the debt, thinking they are actually investing.
A safer and more productive strategy would be to buy a modest home so that debt servicing is manageable even in a cash crunch, and to invest part of your remaining cash flow in more liquid and diversified assets over a long time horizon. After all, your beautiful house can eat meh? Cannot, right?
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