The secret ingredient to building an optimum investment portfolio
Now we will put the principles of diversification into context. In the example that follows, we are going to build an investment portfolio that balances risk and return. Take a look at the two asset allocations below and select the one that offers a higher degree of diversification:
The answer is obvious - Investor B has a more diversified portfolio. The investment is spread across a broader range of asset classes, and the weightings assigned to each asset class are more evenly distributed. Even within the equity investments (the asset class with the highest weighting), Investor B has chosen to invest in the more diversified exchange-traded funds ("ETF") instead of single stocks. On the contrary, Investor A reflects the investment approach of most individual investors - concentrating investments in the Hong Kong stock market, in particular several selective sectors. This is a common misconception: that risk diversification can be achieved by investing in several single stocks.
Let's use the first trading day of the year as an illustration. On that day, the Hang Seng Index dropped 587 points*. The stock holdings of Investor A in Chinese banks witnessed a broad-based decline - China Construction Bank edged down 3%*, Industrial and Commercial Bank dipped 3.4%*, Agricultural Bank of China declined 2.8%*, Bank of China retreated 2.9%*, Bank of Communications dropped 3.1%*, and China Merchants Bank lost 4.4%*. Compared to Investor A, Investor B set a better example for investment diversification. The latter can more effectively weigh between risk and return by investing in assets less correlated with Chinese banking stocks and the Chinese and Hong Kong stock markets, thereby mitigating the risk of investing in a single market.
To find out more about the correlations between different asset classes, you may refer to the correlation table. "Correlation" is a value between -1 and 1 representing the inter-relatedness between two asset classes. When correlation is equal to 1, it means that the two assets are positively related and they tend to move in the same direction; when the value is -1, the two assets are negatively related and they usually move in opposite directions; if the value is 0, then the two assets are not related at all and their trajectories are independent of each other. The following table shows the correlations between different asset classes:
The simplest way to build a risk-diversified investment portfolio is to blend equities with bonds - the two asset classes generally have a low correlation. With reference to the table above, the correlation between developed market equities and US government bonds is -0.26, implying that if the stock markets in developed countries head south, US government bonds may not follow the same trend. In fact, the latter may even climb higher, counter-balancing the risks and returns of the investment portfolio.
To determine the degree of investment diversification, investors should assess their own investment objectives, investment horizon, amount of capital and level of risk tolerance before drawing a conclusion. They should also evaluate the correlation between different asset classes to optimise the asset allocations in their investment portfolios.
In addition to conducting regular portfolio rebalancing - maintaining the weightings of asset classes at the predetermined risk level by buying low and selling high - investors can also perform tactical asset allocation, i.e. actively adjusting asset weightings within the investment portfolio according to the valuations of asset classes and the status of the economic cycle. Simply put, if investors are convinced that a certain asset class will benefit from economic recovery, the asset class should be assigned a higher weighting, and vice versa.
Last but not least, no matter which way stock markets go, investors should always base their investment decisions on objective indicators, such as the macroeconomic situation, corporate fundamentals and valuations. Should there be any questions, remember to seek professional guidance from your trusted investment advisors.
*ET Net, 1 April 2016
In partnership with Hong Kong Ecnomic Times Supplement Team
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