This article was first published on May 2, 2014
What Is Diversification?
It should be safe to assume that many have heard of the investment jargon “diversifying one’s portfolio”. In layman’s term, diversifying is essentially “not putting all of one’s egg in one single basket”.
As defined by Investopedia, diversification can be defined as a risk management technique to smooth out unsystematic risk within a portfolio. In the best case scenario, a fully diversified portfolio would only consist of systematic risks.
What Are Systematic And Unsystematic Risks?
Systematic Risk: The risk inherent to the entire market segment. An example would be the Global Financial Crisis of 2008-2009, where the overall market was affected; a type of risk that is both unpredictable and impossible to completely avoid.
Non-Systematic Risk:A company or industry specific risk that can be reduced through owning stocks in different companies and industries. Non-systematic risks include management change, product recall and regulatory change. An example would be General Motors Company’s (NYSE:GM) recent issue with regards to their ignition switch recall.
How does one execute such a strategy?
Studies have generally shown that a well-diversified portfolio of approximately 30 stocks would have the most cost–effective level of risk reduction, additions beyond that might result in declining marginal benefits.
As Peter Lynch stated, “there’s no point in diversifying just for the sake of diversifying”. One has to have their eye on the underlying as the devil is in the details. In general, increasing the quantity would result in a lower overall risk. But if we invested our whole portfolio in one sector alone, we might end up looking like the patsy in the Dilbert comic strip above.
A common perception would be that index funds are well diversified, but the question would be, relative to what benchmark.
The Straits Times Index (“STI”) Exchange-Traded Fund (“ETF”) (SGX:ES3), consisting of the top 30 companies listed on the Singapore Exchange by market capitalization would be used as an example. As at Mar 8, 2014, the Financial Industry had a 44.32% weightage in the STI Index which to an extent was inevitable given that Singapore is the “Switzerland of Asia”. Another concern of a market weighted index would be the overwhelming domination by larger capitalized entities; the top 10 constituents of the STI added up to 64.26% of the total.
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To construct a more balanced portfolio, investors with portfolios similar to the STI might want to consider holdings in underweighted sectors in the index. Some examples could potentially include healthcare providers like Raffles Medical Group Ltd (SGX: R01) and consumer goods operator Breadtalk Group Ltd (SGX: 5DA) but of course, at the right value.
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The information provided is for general information purposes only and is not intended to be any investment or financial advice. All views and opinions articulated in the article were expressed in Cheong Mun Hong’s personal capacity and do not in any way represent those of his employer and other related entities. Cheong Mun Hong doesn’t own shares in any companies mentioned above.