Worried about making the wrong investment? Diversify.
If you’ve only got a minute:
- One of the most fundamental rules in investment is the trade-off between risk and returns. Generally, the higher the returns, the higher the risk.
- A common way to measure investment risk is “standard deviation”, which measures the price or returns volatility of assets such as stocks, bonds, and unit trusts. The higher the volatility, the greater the likelihood of losing money on that investment.
- Understand your risk profile before investing. This can be influenced by factors such as your age, how much emergency savings you have, investment experience, and risk appetite.
- Diversification is one way of managing investment risk.
One of the chief concerns when investing is the fear of making the wrong decisions. Understandably, this is a very natural fear and one that affects both would-be investors and experienced ones.
After all, we invest with our hard-earned savings and it can be vexing to see investment calls not play out the way we hoped they would. This can happen even if you have done your due diligence and based on the investment climate and/or immediate prospects of a particular stock then, it might have actually been the right decision.
At the same time, it helps to understand that we do not have a crystal ball to peer into the future, and at the point we make an investment decision (even a well-researched one), we do not have the benefit of hindsight.
Just like in life, we’re bound to make mistakes or wrong calls at times. But what we have control over is our ability to learn from them by understanding our personal risk appetite and clearly identifying our investment objectives. By grasping what you are investing in, you minimise the likelihood of making the wrong decision.
With knowledge, we are also able to put measures in place to prevent or minimise such incidences from happening again.
Whether you are a beginner or have been investing for some time, having an awareness of the following can help guide you to make important investment decisions:
- Understanding investment risk and how it is measured
- Hierarchy of risk among asset classes
- Being aware of your risk profile
- Why you should diversify to spread risk
- How to diversify well
By understanding these points and reminding yourself of them regularly, it’ll be easier to select well-suited investment products. They will also help you consider your investment portfolio in its entirety instead of being too fixated on the performance of a single investment.
What is investment risk and how is it measured?
One of the misconceptions of investing is that low-risk is often conflated as no risk. Regardless of whether you are a risk-averse investor or one who is willing to take calculated risks, it is crucial to remember that all investments carry a degree of risk.
A fundamental rule in investing is the trade-off between risk and returns. Generally speaking, when you invest in assets with higher potential returns, you are also likely to be facing higher risk.
Investment risk is the likelihood of investment returns being lower than their expected return where the actual return can be in the form of lower profits or making a loss on the investment.
A common measure of investment risk is “standard deviation”, which looks at the variability of the annual rate of return of any investment.
In technical terms, standard deviation measures the “dispersion of a data set relative to its mean”. In simpler terms, it measures the volatility of any asset (e.g. stocks, bonds, unit trusts, gold) in comparison with its average historical return.
The greater the volatility of returns, the greater the likelihood of making losses on your investment, particularly over shorter time frames. This can be unsettling to some investors, who might prefer lower volatility investments.
The hierarchy of risk across different asset classes
When investing across different asset classes (e.g. stocks, bonds), you should expect that they have different levels of risk.
Based on data on US stocks, corporate bonds and Treasury bills over a 90-year period from 1932 to 2021, we are able to see the general relationship between risk and returns.
From the table, we are able to see that US Treasury bills (US government bonds) are the lowest risk investments of the trio but also had the lowest returns. On the other hand, stocks are the highest risk of the three asset classes but it is also accompanied by the highest returns.
This is why we often hear that stocks are riskier investments than government bonds. At the same time, stocks often have higher upside potential, meaning it generates higher returns in the long run.
Within each asset class, there are also different levels of risk associated with individual securities.
Taking government and corporate bonds as an example, AAA-rated bonds – the highest rated bonds – are lower risk than BB-rated bonds. Given that the Singapore Government has a AAA rating, Singapore Savings Bonds (SSBs), are considered one of the safest investments.
And within corporate bonds, the probability of default— the inability of the issuer to repay the interest on the bond— tends to rise as the credit rating of the issuer declines.
Bonds with a lower credit rating are often accompanied with higher interest payments (called coupons) as compensation to investors for additional risk.
For equities, risks vary between individual stocks and different groups of stocks. Such risks can also be measured by the standard deviation method. For example, emerging market stocks typically have a higher long-term standard deviation than developed market stocks.
Understand your risk profile before investing
As we shared earlier, investors generally have to take more risk in order to get higher returns. Yes, there is a risk of loss, particularly over short time frames but being overly conservative also poses a risk.
For example, not investing or investing only in very low-risk products may result in your savings devaluing through inflation.
Being aware of your risk profile is perhaps the most important thing to take note of before investing. Ever so often, investors are not fully aware of their profile, which leads them to make investments that are not as well suited to them.
Knowing your risk profile helps both your financial advisor and you to select investments for your portfolio which will correlate best to your needs.
Your risk profile is the sum of your circumstances, personality, and preferences. And it also comes down to how much loss you can tolerate on your investments.
Refer to the table below to identify your risk level and corresponding returns target.
Diversify to manage investment risk
Now that you have a sense of the risk-reward trade-off and your risk profile, it helps to know why you should diversify.
While it is true that all investments come with an element of risk and the possibility of making a loss, through diversification, you can mitigate such risks without necessarily holding back your potential investment returns.
Simply put, diversification is all about ensuring that you are not putting “all your eggs in one basket”. By placing your capital in different investments, it reduces the likelihood of your investment from being wiped out.
When risk assets like stocks are sold down during times of market distress, investors tend to buy quality government bonds, which in turn drive up the bond prices. In this instance, declines in stocks are offset by gains in government bonds.
Citing another scenario, sometimes when inflation becomes a concern, stock prices might fall due to worries that the former may move up interest rates. The same dynamics might also raise commodity prices, which can help a diversified portfolio offset some of the losses in stock prices.
By having different assets with different returns and cyclical characteristics, you can cushion yourself from some of the bumps of market volatility in any single asset class.
Types of diversification
Broadly, there are a few major types of diversification. Among which, asset class, geographical, and sectoral diversification are the most common.
Diversification by asset class
This is done by investing in a number of uncorrelated assets. For example, a well-diversified portfolio consists of a balanced allocation of investments in equities, bonds, commodities, property and cash.
A correlation describes the relationship in the movement of prices of different asset classes.
A correlation coefficient of +1 suggests a strong positive correlation, implying that both the asset classes move in the same direction and by a fixed proportion.
A coefficient of -1 indicates a strong negative correlation, that is, the two asset classes move in opposite directions by a fixed proportion. A coefficient of zero suggests no correlation at all.
To use correlations in spreading risk, look at the assets’ long-term correlations. To achieve a diversified portfolio, you need to have asset classes with either negative or low correlations with one another.
Diversification by country & industry
To achieve diversification, a popular practice is to keep any single stock to no more than 5% of your portfolio. That way, even a total loss in one stock would be merely painful rather than catastrophic. That suggests a portfolio of at least 20 stocks.
While it can be argued that having a portfolio of 20 stocks is sufficient to save you from broad market risk, if these companies are in the same geography and industry - they are likely to be highly correlated, then the portfolio will not be well-diversified.
Instead, you should also be looking at achieving diversification within each asset class by investing in different geographical locations and sectors.
This is best explained with equities where each company has its own geographic area of operation and its own industry (e.g. technology, healthcare, consumer staples, property). Diversification can be achieved by spreading investments in different country and industry to minimise the impact of country or industry specific events.
Alternatively, you can also achieve diversification by investing in a range of pooled investment products like unit trusts or exchange traded funds.
Diversification by investment style
Apart from country and industry, diversification can also be achieved through investment style. Stocks can be classified into different categories based on market capitalisation (small-, mid- and large-cap) and style (growth, income and value).
There are 9 categories in total, from small cap growth stocks to large cap value stocks. For example, Amazon is a large-cap growth stock while Ford Motor Company is considered a large-cap value stock. A good mix of stocks with different market capitalisation and style will help you to create a portfolio that may be more resistant to economic shocks.
One other way to diversify is by employing a style that is half income-orientated and growth-orientated like the Barbell Strategy, which has been advocated by DBS Chief Investment Office since August 2019.
When investing, be patient with yourself and understand that in this journey, you are bound to make mistakes along the way.
To minimise these mistakes, it you should understand what investment risk is and how it is measured, be aware of your risk profile so that you pick investments most suited to your financial objectives and how to diversify your investments well.
When investing for your retirement, it also helps to take a long-term view on investing. This means staying invested, even as markets fluctuate. Research has found that the longer the investment time frame, the lower the risk of incurring losses in your stock holdings.
With the right diversification through different investment instruments, you can reap the rewards of investing and still maintain a low exposure to risk.
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Disclaimers and Important Notice
This article is meant for information only and should not be relied upon as financial advice. Before making any decision to buy, sell or hold any investment or insurance product, you should seek advice from a financial adviser regarding its suitability.
All investments come with risks and you can lose money on your investment. Invest only if you understand and can monitor your investment. Diversify your investments and avoid investing a large portion of your money in a single product issuer.
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