AS a rookie investor, one of the most common tips you might have gotten is to diversify your investments. But what does it mean exactly and how do you get down to it? Let's dive deeper into the nitty-gritty of diversification.
What is diversification?
Diversification is a risk management strategy where you spread out your investments across different areas to reduce risks. Think: Don't put all your eggs in one basket.
A well-diversified portfolio will help smoothen the volatility from market influences to ensure you won't lose all your investments when there are major market movements as a result of economic events such as financial crises.
The idea is to ensure that any negative returns from one component of your portfolio can be cushioned by another portion. Also, your portfolio should stand to benefit in one way or another regardless of the economic environment. This is because various asset classes across different industries or geographies react differently to economic events.
Take the Covid-19 pandemic as an example. When the virus first hit the shores of Singapore, airline and travel-related stocks bore the brunt of the impact. But there were also stocks that we know of as pandemic beneficiaries.
Recall the grocery-hoarding frenzy at the start of the pandemic when toilet paper became a prized commodity? That resulted in supermarket stocks such as Sheng Siong and Dairy Farm International (the operator of Cold Storage and Giant, among others) registering significant gains.
A portfolio with investments across different industries would therefore not have been too hard hit by the pandemic. Diversification should, on average, yield higher long-term returns versus putting all your money in a single stock.
How do you do it?
- The top-down approach
This involves looking at how economic factors will affect the overall market in order to sieve out the best stocks to invest in. Investors with a top-down approach will also look at how a particular sector or country is performing based on macroeconomic factors such as interest rates, prices of commodities or even long-term trends such as digitalisation and sustainability.
- The bottom-up approach
This approach places less emphasis on macroeconomic factors and trends, and instead delves deeper into the fundamentals of a stock. Some common metrics include a company's financial ratios, earnings growth, dividend yield and cash flow.
- Combining both approaches through funds
Besides using these approaches to pick individual stocks for your portfolio, you can also use them to build a portfolio of passive exchange-traded funds (ETFs) and/or actively managed funds.
Actively managed mutual funds all have mandates: parameters that determine how funds will be managed. The mandate usually includes either a top-down or bottom-up approach, or sometimes both.
A passive ETF, on the other hand, tracks an index. Indices are predominantly top-down in their approach, although some may include bottom-up factors.
You can therefore combine the top-down and bottom-up approaches in a portfolio by selecting a combination of both actively managed mutual funds and passive ETFs.
Which to go with?
For investors who are looking for cost-effectiveness, passive investing might be a good option. You may not get outsized returns; but hey, you won't be lagging the market either.
The average annual return of the S&P 500 over the last 40 years is nearly 12 per cent, while the average annual return of the STI since its revamp in 2008 is close to 8 per cent - pretty decent compared with simply leaving your money untouched.
This doesn't mean actively managed funds aren't useful. If you are just starting out with not much to spare, passive investment makes more sense than taking on the risks of trying to beat the market.
But over time, you can also look to complement your passive investments with active funds to generate additional returns. Such funds have their place in a portfolio too, as long as that portfolio is a diversified one.
It is tempting to allocate a huge amount of money in the hopes of making the right bet on the "next big thing". Indeed, there are some individual stocks that are capable of generating above-average returns. Tesla, for instance, is one stock that managed to outperform the S&P 500 index in 2020. The S&P 500 in 2020 gained 16.3 per cent while Tesla was up 695 per cent.
But the reality is that we can never be certain whether today's stock market gems will continue to deliver in the next 20 to 40 years. Take American multinational company General Electric, once considered a market darling, as an example. As at July 23, its share price was only about a quarter of what it was worth back in its heyday in 2000.