In an investment portfolio, obvious lack of diversification is easy to identify: along with mismatched risk profiles and underperforming assets, these issues stick out and can be quickly corrected. But the devil is in the details; and it’s these seemingly small but important factors that undermine your portfolio diversification. Here are some of the commonly overlooked issues:
1. The portfolio is not as diverse as you assume
There’s a common tendency to assume diversification, especially with certain types of funds. Straits Times Index (STI) Funds, for instance, are commonly assumed to be well-diversified, as they track the overall market. But this isn’t strictly true:
Keep in mind that Singapore’s largest entities, by market cap, are generally banks. DBS, OCBC, and UOB, for instance, are almost always in the top spots. The other component tends to be real-estate related, such as CapitaLand, or Singapore Press Holdings (despite the name, SPH is a major force in the property market, and owns assets such as Clementi Mall).
This means that, for ST Index Funds that track the top 30 blue chip companies, there is a tendency to overconcentrate in sectors such as finance and real estate. Any factors that impact these industries can inordinately affect the fund, and hence your portfolio if you’re significantly invested in it.
Likewise, a fund that’s a partial-replication fund (i.e., the fund only buys into the biggest companies by market cap, rather than buying the “whole” index) is more concentrated in large, blue-chip companies. If you lack investment in smaller corporations, you might miss out on a small-cap led bull run.
This isn’t to discredit the index fund; rather, the point is that you shouldn’t overconcentrate everything into a single index fund, on the assumption that it’s well diversified.
2. Not accounting for currency fluctuations
As the size of your portfolio grows, it becomes important to consider assets denominated in currencies besides the SGD. When all your assets are in a single currency, the portfolio lacks geographic diversification: it will, for instance, be overly impacted by economic shifts in the APAC region. This is a form of home bias, where our comfort zone prevents proper geographical diversity of assets.
The SGD is almost most sensitive to the movements of the USD (among currencies in SE Asia). So a portfolio that has all its assets denominated in SGD is, by default, more impacted by US policies and changes.
Holding assets in different currencies also provides a possible hedge against inflation. If inflation rates is currently high, for example, you might consider holding assets / currencies in countries experiencing a lower rate of inflation.
Ultimately, holding more than one currency is a form of diversification as well; and one that’s especially important if you have business interests or taxes overseas.
3. You have varied assets, but they are highly-correlated
A typical example of this is investing in gold and silver at the same time. These are indeed different assets; but because the two precious metals often move in tandem, the two are highly-correlated. As such, investing in both at once may not bring much diversification.
The same can happen when you invest in both upstream and downstream companies tied to the same asset. For example: if you invest in silver, and then a silver-mining company and a jewellery company, the assets are quite highly-correlated: a fall in the price of silver is likely to impact all three of them the same way.
To be clear, there are tangible differences between such assets; it’s simply that the difference is not wide enough to truly make for a diversified portfolio. Investors need to be wary of a “comfort zone” effect, where they’re unwilling to stray too far from an industry they like (e.g., an investor who is both a commercial landlord, and owns commercial REITs, is still over-concentrated on real estate).
4. Overlapping index funds or unit trusts
An example of this is having two different ETFs, both of which are tracking gold or tech-related stocks. This is not really diversification, as the two funds are likely to move in the same direction.
Another instance of this is having ETFs in two very similar indices. The S&P 500 and the DJIA, for instance, tend to move in tandem: this is because both indices represent broad swathes of the US economy.
(This is not to say the two are the same, and there are subtle but important differences between them; our point is simply that having an ETF for both may be a redundancy).
For unit trusts, this can be a bit tricky. You may, for instance, have a unit trust that’s focused on a certain industry, such as coal energy. However, another of your unit trusts is focused on China, which is a geographical emphasis.
They two appear different. But peer closer, and you might find the China-based equities fund is heavily invested in coal energy (as China is both the world’s largest producer and consumer of coal).
So even though the two funds are ostensibly different, you may have more invested into the coal industry than you believed. This is where financial advisors or wealth managers become important: part of their job is to investigate the various funds, and ensure you don’t’ end up with too many overlapping assets.
5. Overdiversifying the portfolio
There is such a thing as too much diversification. Once a portfolio becomes too scattered, you’ll find that better performing assets are constantly weighed down by a deluge of smaller, underperforming assets.
This also brings about an important question: If an over-diversified portfolio delivers returns that can be matched by a lower-risk option – such as just leaving the money in your CPF or a fixed deposit – then why bother with those assets at all?
Diversification is a matter of balance: not too much, not too little. It’s also a balance that shifts with underlying market conditions, and changing financial goals.
Do be wary of phrases like “automatic diversification.” It may just mean a service that thoughtlessly sells you overlapping ETFs; or it could be funds cobbled together by robo-advisors / algorithms that match your risk profile, but are far from optimised.
Reach out to us at Single Digit Millionaire for help if you feel your portfolio needs improving, and we can put you in touch with trusted experts.
