DIVERSIFICATION IS THE BEST DEFENCE
With Singapore entering Phase 2 (Heightened Alert) from 16th May to 13th June, it seems like a pipe dream that our travel bubbles with Hong Kong or Australia will start anytime soon. Many of us are also contending with working from home and jostling for space (and quiet) with other family members and school-going children who are on home-based learning. Would travel bubbles ever happen? How susceptible am I to COVID-19 even if I am vaccinated? What does the new norm even look like?
The tightened measures seem to be working but no one knows for sure, yet.
Uncertainties seemed to have arrived swiftly and without warning, but the reality is that they’ve never left. It’s the same with the market.
What uncertainty? Hasn’t the market recovered?
Markets have performed exceptionally well given the situation that we are in – 1.82 million lives1 and estimated US$3.94T of global GDP2 lost in 2020 alone; even with the vaccine rollout, we are still gripped by the COVID-19 pandemic. It was only on 29th April this year when the highest number of daily cases were recorded globally3. Economies are recovering amidst an anomaly – this time, the markets are at a high compared to economic recoveries of the past, when markets were usually at the the lowest.
Source: MSCI.com; Past performance is NOT indicative of future performance
If you have invested in portfolios which aren’t diversified, i.e. exposed to 100% equities, you might have enjoyed a very stellar performance from your portfolio as global equities have returned 79% since March 2020.
And psychologically, when you are on a roll, the brain puts your “expectations on autopilot: More of the same is on the way4.” Even Jack Welch, the former leader of General Electric (GE), admitted that he got carried away on his own hot streak of deal-making. He later disclosed that when he bought the Wall Street brokerage Kidder Peabody, he didn’t know much about it – he just felt that he was on a roll, and GE eventually lost US$1B on this investment4.
“Because (overconfident investors) so often think they know what’s coming, they are forever buying or selling something. And yet they know less than they think they do. The portfolios of those who trade the most underperform the holdings of those who trade the least by an amazing 7.1 percentage points a year4.”
Warren Buffett wrote: What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids the big mistakes5.
So how badly can an undiversified portfolio perform?
When global equities market last dropped 30% in March 2020, a portfolio with a 100% exposure to equities that had already been floundering could suffer an even worse drop than 30%:
Portfolio performance of an undiversified stocks portfolio in Mar 2020, contributed by a Friend of Unicorn’s, invested 100% in equities
How many investors can take a drop of 83% without losing sleep? And what if it’s 60-80% of the one’s total assets?
One lesson we can take away from this is to DIVERSIFY, DIVERSIFY, DIVERSIFY. With stocks that might not have been as resilient or well-researched, the crash that they will suffer during a stock market drop of 30% might be much worse (i.e. 83%).
Without diversification, an opportunity like last year’s can become a disaster.
Unicorn’s Value Investing Portfolio Services (VIPS) turned it into an opportunity as the diversified portfolio of equities, cash and gold hedged the portfolio well enough so that the overall portfolio value was hardly affected when the global equities dropped 30%, and the portfolio did not have to spend too much time playing catch-up:
How does diversification accomplish this?
According to Investopedia, “a diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.”
Due to the diversification, short-term performance might be compromised – it’s like buying insurance for your portfolio. This means that when the storms come, there is a higher chance that the portfolio will weather it well with the positive performance of some asset types neutralising the negative performance of others and this also works only when asset types are not perfectly correlated with one another. This results in lower volatility and better returns in the longer term, as the portfolio did not have to suffer massive shocks when equities perform poorly – a 50% drop in the portfolio would mean that it must perform 100% just to get back to square one.
On top of Diversification or Asset Allocation, Asset Selection is also imperative. After researching into the sectors and the companies that Unicorn thought would continue to do well in 2020 – we switched our equities to focus on structural growth companies in tech and healthcare. As we believe China to be a long-term winner, we continued our buy into China. These selections resulted in our overall performance of 18.9% for our cash portfolio last year (as seen in the graph above).
If you think you might have a portfolio that might not be properly diversified or not sure of which asset classes to select, do speak to your Unicorn Consultant if you would like know more – we will also share on our tactical move in our next article. Look out for it!
Note: We had increased the frequency of our communication with you during turbulent times. We will continue to communicate monthly with you during usual times.
- Jason Zweig, Your Money & Your Brain
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