Investment approaches and diversification

Investing can be complicated. It’s no longer just putting your money into fixed deposits. Or buying blue chip shares and holding it for 20 years. Today’s investment landscape can be very dynamic and constantly changing.¹ As an investor, it is important to take the time to understand basic investing principles and the different asset classes to gain from your investments over the long-term.¹

As an investor, you have an enormous variety of potential assets to invest in to build your investment portfolio. Each asset class brings with it its own levels of risks and returns.¹ Briefly, here are the three most common asset classes in ascending order of risk.¹

Cash in the form of a bank deposit like a fixed deposit is the simplest, most easily understandable investment asset and the safest.¹ If you open an FD with a bank, you will know the exact amount of interest you will earn – plus you will sleep well at night knowing you will get your capital back.¹

Bonds are debt instruments in which investors effectively loan money to a government or company, in exchange for periodic interest payments plus the return of the bond’s face amount once the bond matures.¹ Bonds carry a slight risk and the value can fluctuate based on different factors, but it’s mainly influenced by prevailing interest rates.¹

Equities are shares or stocks in a company. To invest in equities, you can buy shares or stocks directly in a company to gain from the company’s success via increases in the stock price and through dividends.¹ Or you can invest through mutual funds (or unit trust funds as more commonly referred to in Malaysia), which are pooled investment vehicles managed by investment managers, exposing you to a basket of stocks, bonds or other investment vehicles as prescribed by the fund.¹ You make returns from mutual funds through distributions in the form of dividends, interest and capital gains.¹

In addition to cash, bonds and equities, other alternative asset classes you could invest in include real estate, commodities and hedge funds.¹

The question of whether you should invest in FD, bonds, equities or alternative investments is a complicated one. If you were 100% risk-averse, you may just choose to park all your money in fixed deposits because you know it will be safe. But would you be able to grow your wealth sufficiently to meet your long-term financial goals that way? That is the question you have to ask yourself.

Seasoned investors would diversify their investment portfolios by investing in a variety of asset classes, with the asset mix reflecting their tolerance for risk.¹ This asset mix is typically the most important aspect of managing your investment portfolio, so understanding how the various asset classes have performed historically is useful to help you make your choices.²

Enter the asset allocation quilt.

Looking at the asset allocation quilt (see fig. 1), a few things stick out…

• It is difficult to pick the best and worst performing asset class in a given year²
• You can learn a lot about how markets function by looking at performance in this way²
• Of the three main asset classes, equities provided the best returns, next was bonds, followed by cash based on 10-year annualised performance.

You may argue that this quilt is not representative because it is US-market centric. So let’s take a look at another asset allocation quilt (see fig. 2) based on the UK market.

Calculating the average returns from the different asset classes over the whole period, equities returned an average of 7.7% annually between 2004 and 2017.3 The next best performer was real estate, followed by government bonds at 2.7% and cash at 2.2%.³

HSBC’s own data compiled from Morningstar and HSBC Global Asset Management also supports the historical trend of equities and bonds outperforming cash as an asset class. Here is our asset allocation quilt (see fig. 3).

Yet, many investors still overlook bonds in favour of fixed deposits.⁴ But historical levels of achievable income have dropped in recent years as interest rates have been slashed in the wake of the global financial crisis.⁴

With interest rates expected to stay lower for longer in a highly levered global economy, it will be challenging to generate healthy income by parking your investments in low interest fixed deposits.⁴ This coupled with the fact that fixed deposits don’t account for inflation, make it a debatable asset class as part of your portfolio.⁵ In place of fixed deposits, investment grade bonds may offer higher returns when combined with higher risk assets like equity.⁵

As the chart shows (see fig. 4), an investment portfolio comprised of 60% equities / 40% bonds had a higher annual return and lower volatility over a 10-year period compared to a portfolio of 60% equities and 40% cash.

Beyond better historical returns of equities and bonds, the impact of inflation on your investments is another reason fixed deposits may not be your best bet. Generally speaking, fixed deposits don’t pay enough in interest to keep up with the rate of inflation.⁶ If you only invest in FD, you’ll lose your standard of living over time as inflation outpaces your interest income.⁶

Malaysia’s average inflation rate from data provided by the World Bank from 1960 to 2017 stands at 3.1%, which is roughly around the global average of 2%-3% per year.⁷ A quick search online of rates being offered by banks in Malaysia for 1-month fixed deposit show a range between 2.70% to 2.95% per annum as of 22 July 2019. Doing some quick math will show you that you are still losing somewhere between 0.15% and 0.4% to inflation. So all you are doing is “losing money safely.”⁸

Inflation is said to be one of an investor’s worst enemies.⁸ Inflation or what many of us refer to as “the cost of living” describes the environment of generally rising prices of goods and services.⁸ As prices rise, our purchasing power as consumers decrease.⁸ When you invest, what you are essentially trying to do is beat inflation to maintain your purchasing power over the long-term.⁸

And the best way for most people to beat inflation is to invest in a combination of equities and bonds.⁸

So we’ve learnt that investing in equities and bonds provide better long-term returns compared to fixed deposits, and can beat the impact of inflation.

What’s next?

For most investors, building a diversified investment portfolio is the best strategy for all market and economic environments.⁸ The benefits of diversification include:

A crucial element of investing for most investors is not to lose money.³ There is always a risk with investing, but diversifying helps mitigate that risk.³

Whilst diversification may not ensure profits, it can help to reduce the impact of market volatility, leaving an investor less at the mercy of market extremes.⁹ Compared to a single asset investment, a diverse range of investments could provide improved risk-adjusted returns and a smoother volatility experience.⁹

The frequency and extremity with which your investments rise and fall determines your portfolio’s volatility.³ Diversifying your investments can give a greater chance of smoothing out those ups and downs.³

The reality is the best performing asset class in one year, can be the worst performing the following year.⁹ If your portfolio is made up of only one asset class, the outcome is more variable and the risk could be much higher.⁹ Diversification aims to reduce risk by allocating investments among various asset classes, currencies and geographies that react differently to market movements so a fall in the value of one asset class can be offset by an increase in the value of another.⁹

Diversification allows higher returns in one asset class to compensate for lower returns in another within your portfolio so that you are not exposed to the risk of only one investment theme.⁹

To benefit from investment diversification, your portfolio must have assets that complement each other by reacting in different ways to market movements.⁹ In financial terms, assets that have low correlation.⁹

So, you are sold on equities and bonds over FD, that you need investments that beat inflation, and diversification is a good strategy. But figuring a diversified investment portfolio that meets your needs seems rather daunting… and you think you may need help.

We may just have the help that you need to match your investment needs and goals to global investment portfolios with diversified asset allocations aligned to your risk tolerance. These global investment portfolios offer dynamic asset allocation, meaning allocations are regularly adjusted in response to changes in valuations and market circumstances; they are risk-focused with asset allocation tailored to different risk profiles, and they are cost-efficient to maximise net returns to investors.

In addition, you can also take advantage of three different fulfilment strategies we have in place for the global investment portfolios to maximise your returns.

Active investment funds aim to outperform a benchmark/index by analysing the market and then investing where the fund manager believes there is the greatest potential for outperformance.

Key benefits:

• Access to expert teams of analysts and fund managers
• Potential for higher-than-index returns
• Ability to react to market conditions
• Poor performing companies can be identified and avoided
  

Passive investment funds aim to simply track the performance of a market capitalisation weighted index. The fund manager invests in accordance with a pre-determined strategy that does not involve any forecasting. Includes index tracker funds and ETFs.

Key benefits:

• Low-cost access to market returns
• No material risk of underperformance relative to the index
• Simple and transparent
• Diversified – gains exposure to all stocks in an index

Alternative weighting schemes, sometimes referred to as ‘Smart Beta’, use a different approach than market capitalisation to construct an index. Examples include indices based on a stock’s volatility, dividends or some measure of fundamental value. Alternative weighting scheme funds aim
to improve on the risk return outcome of traditional, market cap passive management.

Key benefits:

• May circumvent some of the flaws of traditional passive investing – reallocates away from overvalued stocks
• Potentially superior performance relative to traditional index
• Smart index construction – weights based on something other than market capitalisation i.e. HSBC Economic Scale Equity 4 Systematic, rules-based implementation

To find out more about how these strategies can benefit investment portfolios and learn more about how you can use our global investment portfolios to build on your current investments, contact your Relationship Manager today.

Sources:

1. Investopedia, A beginner’s guide to asset classes, 19 July 2019.
2. A Wealth of Common Sense, Updating my favourite performance chart for 2018, 8 January 2019.
3. Schroders, 14 years of investment returns: history’s lesson for investors, 29 November 2017.
4. Pimco, Bonds versus term deposits: tackling the misconceptions, October 2015.
5. Australian Bond Exchange, What is the difference between a term deposit and a bond?, undated.
6. The Balance, Certificates of deposit explained with pros and cons, 30 May 2019.
7. The Global Economy, Malaysia: Inflation, undated.
8. The Balance, Inflation and investing strategies, 15 May 2019.
9. HSBC Bank Malaysia Berhad, Portfolio diversification: why it matters and how to get started, undated.