By now you’ve heard the “balanced, well-diversified portfolio” speech a dozen times, and it always has the same issue: almost any product can be called “balanced” or “well-diversified” by someone with a vested interest in selling it; and these days, those same people will be the ones nagging at you to let them “optimise” your portfolio. So let’s take the opposite route: rather than cram more stuff into your portfolio to “diversify” it, let’s look at what you might need to take out to get better returns; and what exactly optimisation means:
What is portfolio optimisation?
It’s easiest to see this in one of two ways:
1. Find a combination of assets that offers the highest expected return for your risk appetite.
For example:
You have a low risk appetite as you’re nearing retirement. Optimisation in that case could mean finding a mix of bond, bond funds, annuities, or cash products that give you the highest possible return, without venturing into higher risk assets like equities.
Alternatively, you’re young and have a high-risk appetite, and you’ll be damned if your retirement consists of one sad coffee shop visit per night. Optimisation could mean ditching the safer low-return products, and going for the highest possible gains with equities or derivatives.
2. Find a combination of assets that has the lowest level of risk, for your required return.
For example:
You know you need a 7% return from your portfolio. You then rearrange the stocks, bonds, real estate, etc. to generate that 7%, but at the lowest possible risk – so you diversify those assets, make sure they’re lowly-correlated, perhaps include your CPF, and so forth.
They’re both flip sides of the same coin, but you can pick one approach as it makes the whole strategy easier to conceptualise and plan.
This is at the level of a lay investor by the way, and if you really want to get into this, there’s a bunch of concepts like Modern Portfolio Theory (MPT), Behavioural Portfolio Theory (BPT), the Black-Litterman model, and so forth.
But since it’s impractical to go through an overpriced seminar for all this – and because some of these theories are the equivalent of throwing a bunch of chopsticks on the floor and pretending you’re an I Ching master – let’s go the simpler route of knowing what to look out for.
Some warning signs your portfolio isn’t optimised:
- It’s too concentrated
- It’s not concentrated enough
- Misalignment with market conditions
- Indirect duplication of assets
- High churn rates and transaction costs
1. It’s too concentrated
This is when all the assets are in one place, such as if 80% of your investment is your property (and yes, I am implying the average Singaporean in 2024 pays way too much for their property. Single digit millionaires who bought condos should feel attacked.)
This affects optimisation, in that you may be taking too much of a risk to obtain your desired level of return. If you want a return of 7% for example, and you put most or all of your money into your condo, then your condo unit pretty much has to appreciate at a sufficient rate or you’re done: your retirement is going to consist of driving a Grab past the age of 65 and railing at the government’s bloody cooling measures.
The way around this is not to hedge all your bets on one asset. You need to reallocate your capital, such that you’re invested in a mix of stocks, bonds, etc. That ensures that one move from the government or market won’t shut down most of your portfolio performance.
2. It’s not concentrated enough
Portfolio management is something of a tightrope; go too far in either direction (concentrated or diversified), and the returns will probably see a fall. So there is such a thing as overdiversification:
Think of it as being one of those run-down corner shops that never seem to get anywhere. The owner doesn’t bother tracking what sells or what doesn’t, and just piles on all kinds of scrambled merchandise: some make money, others just get thrown out eventually and lose money. Overall revenue becomes a matter of sheer luck.
That’s sort of what happens when you over diversify a portfolio: the top performers are pulled down by a multitude of mediocre or underperforming assets. And because there’s so much stuff in the mix, it also becomes harder to track what’s working and what’s not.
Most of the time, this happens when you’ve been buying things from a mix of banks, insurers, robo-advisories, etc. for years on end, without ever checking your investments as a whole.
A little tidying up is needed here, and that usually means burning a few weekends sifting through your various assets and divesting yourself of the weaker ones (or you can just hire a financial planner to do it for you; they’re basically the garbage disposal service for hoarders’ portfolios).
3. Misalignment with market conditions
This is another symptom of not checking your portfolio for years on end. Look, I get that no one likes to have that sit-down with their financial advisor, and the 60 minutes of charts and inane small talk that almost invariably follow – but unless you’re willing to learn how to rebalance your portfolio on your own, you need to do it.
Failing to rebalance is how some people end up still having stocks in Kodak or Snapchat, or holding on to commercial real estate with a year of vacancy. The market moves, companies rise and fall, and your portfolio needs to move with it.
Granted, this is more true of some assets than others – hospitality and toy companies see cyclical swings, whereas low cost providers of essentials (e.g., supermarkets) tend to see the same tortoise-like performance all-year round. But if you want a portfolio that needs less in the way of constant rebalancing, it may not be optimised. Think hard about your financial goals, and if the convenience is worth it.
4. Indirect duplication of assets
This is when you buy the same thing multiple times, albeit indirectly. For example: you buy three lots of Sony, and then invest in an equities fund that puts a fair amount into Sony. Or you buy a ton of shares in banks, and then invest heavily into an ST Index fund, where the bulk of companies are also in fact banks.
This can be a bit tricky, because buying into a fund – especially an index fund – can create the illusion of diversification. You might assume that the fund is a wholly separate thing from the stocks or bonds you’ve picked, whereas you may just be buying more of the same.
This boils down to looking inside your various funds (including insurer sub-funds), and ensuring you have a clear idea where your money’s going. You do need to pick through the occasional prospectus or report to figure this out though, so don’t just ignore them.
5. High churn rates and transaction costs
A couple of years ago, I had a friend who was eager to invest using a free algorithm, which was allegedly used by all the top banks and hedge funds. This algorithm would track stock prices and make trades for him, and there was no cost: it would just take a small cut of each winning trade.
We wondered what sort of super-secret proprietary data the algorithm was using, but after three straight years of terrible performance, we both figured it out: the answer was nothing.
The algorithm did nothing but churn – repeatedly buy and sell with high frequency, with no real reason. Some of the trades were bound to be winning trades, from which it would take a cut – but most of the trades were losing, and that came out of my buddy’s pocket.
It seems stupid, but it still happens: financial algorithms or “experts” who encourage constant trading, feeding off your wins and leaving you to absorb your own losses. It may be done through an app or through face-to-face relations, but see it for what it is: an unnecessary churn rate, which leaves you with potentially higher transaction fees, and more losses than wins.
This is also why you question financial advisors who constantly ask you to “sell X, buy Y” almost every time you meet, as if you’re some kind of trader. Optimising your portfolio may mean dropping them, and reducing your churn rate (or at the very least, look at the transaction fees and see if you can lower them).
If you need specific help on products or investments, talk to a qualified expert; in fact talk to more than one, and look for the general consensus between them. But given the evolving nature of your portfolio, the key is to pick the ones who are with you for the long term – not just the ones who are out to sell, pocket a quick buck, and leave you with a nonsensical asset mix. Reach out to us on Single Digit Millionaire too, if you have any questions.
