The Importance Of Diversification

Imagine if you invested your entire life-savings into an airline stock expecting a boom in air travel to drive your investment. However, safety concerns with the airline’s planes grounds the entire fleet indefinitely and all flights are cancelled. The probability is the share prices of the airline’s stock will drop and your portfolio would experience a decline in value.

If, however, you had spread your investments to include other transportation-related stocks like shipping, rail or toll way operators, only part of your investment portfolio would be affected. There is also a possibility that other transportation-related stock prices would rise as people turn to alternative forms of transportation. You could also go a step further and spread your investments beyond transportation-related stocks, and invest in companies from different types of industries.

Remember the age-old advice: Don’t put all your eggs in one basket?

It is sage advice for investors. Diversification ensures that by putting your eggs in different baskets, you will not be creating an unwanted risk to your capital by being too heavily weighted in one specific sector or with a particular company being slanted one way or another¹. Investopedia defines diversification as “a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximise returns by investing in different areas that would each react differently to the same event.”²

Although diversification does not guarantee against loss, it is a critical component of reaching long-term financial goals while minimizing risk². As such, it is important to learn how to accomplish true diversification in your investment portfolio².

So why do many of us still choose to put all of our eggs in one basket? Like only investing in Malaysian blue chip stocks or only accumulating properties for investment. Perhaps it is because we don’t truly understand the benefits of diversification.

Low correlation - To benefit from investment diversification, your portfolio must have assets that complement each other by reacting in different ways to market movements; in financial terms, your assets should have low correlation⁵. To build a diversified portfolio, you should look for assets that have a correlation closer to zero – it doesn’t matter if it is negative or positive correlation. It means that the assets have different reactions to market movements⁵.

Balancing risk and reward - Whilst diversification may not ensure profits, it can help reduce the impact of market volatility, leaving you less at the mercy of market extremes⁵. Compared to a single asset investment, a diverse range of investments could provide improved risk-adjusted returns and a smoother volatility experience⁵.

Lower risk - The main reason for diversifying is that it lowers your overall risk³. The more you spread your assets out, the less likely it is that a single event will negatively impact your investment portfolio³.

Think about this scenario: If you invested all your money in a single stock and that stock loses 50% of its value over a one-year period, you would have lost 50% of your portfolio³. But if that stock only makes up 5% of your entire investment portfolio, the huge 50% decline in value wouldn’t impact you as much³. That’s the great thing about diversification – it lowers risk and allows you to ride out just about any economic downturn³.

Different investment styles - There are multiple types of investment strategies with value and growth strategies being the two most common³. Value strategy tends to focus on the fundamental strength of a company and its management team, and whether that company’s stock price is undervalued based on estimates of its true worth³. Meanwhile, growth strategy would focus on how fast the company has been growing and if new products or other competitive advantages would drive future earnings and benefit the stock price³.

If you were to only choose one approach, you would miss out on the benefits of the other³. By spreading your investments across both strategies, you can enjoy the benefits of each³.

Limits home country/region bias - “Home country/region bias” is an investor’s natural tendency to be attracted to domestic markets³. For example, because we are more familiar with our local Malaysian economy and market, we may only want to invest in stocks listed on Bursa Malaysia or buy local unit trust funds³. The downside is that home country/region bias limits your willingness to invest in other markets that may be more lucrative, simply because they are outside your comfort zone³.

When you diversify, you force yourself to work past your home country/region bias³. This opens you up to international markets, which ultimately reduces your risk during times of domestic economic recession³.

Provides more opportunity - The bottom line: diversification opens you up to more opportunities³. While additional opportunities could theoretically expose you to more risk, the hope is that you will make smart choices that bring balance to your investment portfolio³.

For example, because your comfort zone is to invest in Malaysian stocks, you may forego an opportunity to invest in a potentially profitable global real estate investment because you don’t feel comfortable³. But if you are already used to the concept of diversification, you are much more likely to give a good opportunity outside your comfort zone due consideration³.

The most popular form of investment diversification is asset allocation¹. By having elements of different investment classes – so called assets – in your portfolio including stocks, bonds, cash, real estate, gold or other commodities, you can protect your portfolio from losing too much of its value from the result of consisting of only one declining asset category¹.

Different assets such as bonds and stocks will react differently to adverse events like a global economic downturn or internal shock². A combination of different asset classes will reduce your portfolio’s sensitivity to market swings². For example, bonds and stocks or equities generally move in opposite directions, so if your portfolio is diversified across both areas, negative movements in one asset class will be offset by positive results in the other².

In a 10-year investment portfolio, asset allocation is responsible for 85-90% of the performance or success of the portfolio, while the manager of the portfolio contributes 5-10% and timing of investments 0-5% of performance⁶.

Beyond asset allocation, you also need to consider location as an investor². Diversification means you should look for investment opportunities beyond your own geographical borders as well². For example, volatility in Malaysia may not impact stocks and bonds in the United States or Europe, so investing in those parts of the world may minimise and offset the risks of your investments at home².

While there are many benefits to diversification, managing a diverse portfolio can be challenging – especially if you have multiple holdings and investments² Plus investment costs of buying and selling, from transaction fees to fund management fees to brokerage charges, can be expensive².

This is where HSBC can provide answers to your investment needs.

As one of the world’s largest banks, HSBC offers a portfolio of diverse local investment opportunities supplemented by a range of global funds that provide diversification through asset allocation and geographical locations.

For investors who may find managing a diverse portfolio challenging and who would rather leave the complex decisions in the hands of experienced fund managers, we have a global portfolio investment opportunity which may appeal to your investment needs. This global portfolio fund offers diversification benefits via multi-asset allocations spanning across different geographical locations aligned to your individual risk profiles.

The global portfolios feature:

Dynamic asset allocation

• Portfolios designed to provide a smoother investment experience, relative to a single asset class investment.
• Asset allocation is the key driver of performance.
• Allocations are regularly adjusted in response to changes in valuations and market circumstances.

Risk focused

• A range of portfolios for different risk profiles.
• Asset allocation tailored to risk profile.
• Asset allocation construction process repeated on a regular basis to ensure each portfolio remains in line with its long-term risk profile.

Cost efficient

• Efficient implementation of the desired asset allocation.
• Cost should be a significant consideration for investors as all costs impact net returns.

Meanwhile, for those of you who prefer a more hands-on approach, you can take advantage of HSBC’s enhanced Portfolio Allocation Service (PAS), which provides investors with a Reference Asset Mix for their unit trust holdings based on their respective risk profiles. Based on HSBC’s needs-based investment approach, PAS allows investors to get guidance and information through our online banking platform while maintaining control over investment decision-making. Through PAS, you can receive guidance on a

Reference Asset Mix portfolio allocation to construct a diversified investment portfolio which fits your risk tolerance.

Key features of enhanced PAS include:

• Providing an illustrated breakdown of asset mix with percentage allocation on core asset classes as reference matched to different risk profiles suggesting ways that an investor within a particular risk profile may want to diversify an investment portfolio.
• Expanded Reference Asset Mix to include global fixed income and crossover credit as well as global REITs in core asset classes in addition to existing core assets of global equity, Asia-Pacific equity excluding Japan, Asia-Pacific fixed income excluding Japan, Malaysian equity and Malaysian fixed income.
• The reference volatility of the Reference Asset Mix is designed for three different risk profiles ranging from reference volatilities of 11% (Risk Profile 3), 14% (Risk Profile 4) and 17% (Risk Profile 5).
• Clear reference for how you can construct a diversified portfolio based on your risk profile.

With the PAS Reference Asset Mix as a guide, you can invest in funds from HSBC or other channels to build your diversified investment portfolio.

To learn more about investment diversification and asset allocation, and how we can potentially help you achieve your long-term financial goals by spreading your investment eggs in different baskets, speak to your Relationship Manager today.

Stocks do well when the economy grows⁴. Investors want the highest returns, so they drive up the price of stocks⁴. They are willing to accept a greater risk of a downturn because they are optimistic about the future⁴.

Bonds and other fixed income securities do well when the economy slows⁴. Investors are more interested in protecting their holdings in a downturn⁴. They are willing to accept lower returns for reduced risk⁴.

Commodities don’t follow the phases of business or market cycles as closely as stocks and bonds⁴. Instead, the prices of commodities like gold, wheat and crude oil vary with supply and demand⁴. For example, oil prices would rise if there is a supply shortage and vice versa⁴.

Sources:

¹The Balance, Why diversification is important to your portfolio, 27 December 2018.

²Investopedia, The importance of diversification, 29 March 2019.

³Entrepreneur, The importance of portfolio diversification for your investments, 20 July 2017.

⁴The Balance, Diversified investments with examples, 10 April 2019.

⁵HSBC Global Asset Management, Portfolio diversification. 6 HSBC, Portfolio Allocation Service.

⁶HSBC, Portfolio Allocation Service.