Moderating risk through diversification
This article is one of six pieces, published between October 2 and 7, in support of the Bermuda Stock Exchange World Investor Week Quiz Challenge. Each article has a question embedded. Once you have answers to all six questions and send them to firstname.lastname@example.org for a chance to win a prize of a $2,500 Bermuda securities portfolio.
Diversification embraces the notion of preserving principal through good times and bad by not keeping all one’s eggs in the same basket. In most cases, investors would be wise to construct a portfolio that includes an intelligent mix of fixed income, equities, cash and possibly other asset classes. Having a balanced portfolio improves the odds of reaching important financial goals while experiencing an acceptable level of market price volatility.
While legions of financial pundits regularly attempt to forecast the direction of the markets and prognosticate which asset classes will do best over the next year or two, history shows these predictions are often inaccurate. What we do know is that different asset classes perform well during different times while others do not.
Moreover, even within a particular asset class subsector returns can be quite divergent. Year-to-date the S&P 500, a broad measure of the US stock market, is up about 12 per cent, but within the index the energy sector has declined more than 8 per cent at the time of writing. Therefore, a stock portfolio heavily concentrated in oil and gas companies would have experienced a high level of downside risk this year.
Investing across a wider spectrum of regions and countries provides a further level of diversification. Central bank policies, government agendas, demographics and economic growth drivers vary considerably from country to country. Spreading your bets across multiple regions reduces country-specific risk.
While regional exposure outside of an investor’s homeland can reduce country risk, this strategy generally also creates some currency risk. US dollar-based investors, for example, had something to brag about over the last two years ending in 2016, but year-to-date the greenback has been under severe pressure while investing in other currencies, such as euro-denominated securities, has paid off.
Despite the potential for currency risk, investing abroad has appeal from both a risk and return standpoint. North American investors who focus exclusively on local markets may be missing out on growth opportunities elsewhere. For one thing, emerging markets are on the rise again. China, the largest of the EM’s countries, has seen its share of the world market capitalisation soar from less than 2 per cent in 2003 ago to over 10 per cent today.
Importantly, diversification does not mean beating a benchmark every month, but rather focuses on protecting the total portfolio against large swings in value. Proper diversification ensures some portion of the account is doing well, or at least holding up during challenging conditions.
During the financial crisis in 2008, the S&P 500 stock index fell about 37 per cent, but US Treasuries, as measured by the Barclays US Treasury index, were up 13.7 per cent. Gold also proved to be an attractive diversifier, increasing in value by about 6 per cent for the year. Maintaining a balanced portfolio during this tumultuous period would have eased the pain somewhat.
There are currently 13 publicly held companies listed on the BSX representing seven diverse industry sectors. Name the sectors.
The most basic building block of a diversified portfolio is an acceptable ratio of equities to fixed income. Looking at historic investment returns over time, the month-to-month price changes in these asset classes are generally uncorrelated, meaning that more often than not stock and bond prices move in opposite directions.
This inverse relationship also makes sense intuitively. When geopolitical uncertainty and economic fear prevail, investors demand the safety of bonds and push up fixed-income securities’ prices. But when the coast is clear, investors clamour for the extra return traditionally provided by equity investments as the so-called “risk trade” moves in the other direction.
A diversification issue I have run into frequently over the years, is single stock concentrations. Often an individual comes in with a large holding in one security, perhaps because they worked for the company for a long time and were allowed to purchase shares at a favourable price.
In this situation, I make a point of explaining the risks of single-security concentrations and typically help them set up an aggressive diversification plan. Moving forward on this plan is especially important if the person is retiring or otherwise changing their objectives. Holding a large percentage of one’s portfolio in a single security takes on an extremely high, and probably intolerable level of company-specific risk.
Whether investing on one’s own or hiring the services of a professional, diversification should be a cornerstone of your strategy. Proper diversification helps build and preserve wealth over time without causing excessive volatility and sleepless nights.
For more information about the BSX WIW Quiz Challenge, see the PDF attached to this story under Related Media or go to www.bsx.com
Bryan Dooley, CFA is the Senior Portfolio Manager and general manager of LOM Asset Management Limited in Bermuda. Please contact LOM at 441-292-5000 for further information
This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their advisers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority