“Don’t put all your eggs in one basket.”
This is an old saying that remains relevant, especially when it comes to investing. If you put all your eggs in one basket and that basket gets knocked off the table, all your eggs will break.
If you had put only half your eggs in that basket and put the other half in a carton in the refrigerator and the basket fell off the table, you will be glad to still have half your eggs safely stored in the fridge.
Even gamblers know this. Take roulette for example.
The odds of betting on a single number and winning is 35 to 1 (2.60%) and the odds of a 2 number combination increases your chances to 17 to 1 (5.3%). Once you increase to a 4 number combination, that increases your chances to 8 to 1 (10.5%)!
But the definition of a diversified investment portfolio is not the same for all investors.
Especially for those with different levels of investing expertise.
For someone who is new to investing, a diversified portfolio could be investing in 50-500 stocks like STI and S&P 500 index funds that tracks all the stocks in the indexes and bond funds in a defined asset allocation.
But for someone who has in-depth experience and knowledge in fundamental and technical analysis of stocks, a diversified portfolio could be as simple as investing in a carefully curated list of 5-10 stocks. That's because most people wouldn't have enough time to properly monitor and analyse more than 10 stocks regularly.
My reasons for building a diversified investment portfolio
There are many reasons why we need to diversify our investment portfolios. Most of the reasons are very unique to each of us based on our circumstances and it's impossible to list them all in this article. So I'm going to focus on the main reasons why I'm diversifying my investment portfolio.
I want to be able to sleep at night
The main reason I built a diversified investment portfolio, is to be able to sleep peacefully at night without thinking about how my investments are performing. Yes, sleep is that important for me.
Many years ago, I tried my hand on trading for the first time by shorting a stock and it created a lot of anxiety for me even though the trade was only a small amount of money. It affected my performance at work because I wasn't able to concentrate. Within a few hours, it was clear that I wasn't cut out for day trading so I closed my position at a small loss.
Now, I only make long term investments that I can afford to hold onto for years without having to check on its performance too frequently.
Not having to continuously checking on how my investment portfolio to see how it is performing also allows me to focus on important things like career, fitness, lifestyle, and being able to take some time to write on this blog.
I want to avoid taking on unnecessary investment risks
There are 2 two broad types of risks when it comes to investing:
- Asset (unsystematic) risk: Risks that come from the investments or companies themselves, which include the success of a company’s products, the management’s performance and the stock’s price.
- Market (systematic) risk: Risks that come with owning any asset, even cash. The market may become less valuable for all assets for various reasons, such as a change in investors’ preferences, a change in interest rates or some other factors such as war or disaster.
You can diversify to mitigate asset risks and I'll elaborate on how that can be done in the later part of the article. Market risks however, is both unpredictable and impossible to completely avoid.
Take the COVID-19 pandemic for example.
No matter how concentrated or diversified your portfolio is and regardless of the asset class you chose to invest in, nobody could avoid that sharp drop in their portfolio valuation in March 2020.
You could mitigate some of the losses by hedging against your portfolio by buying put options as a form of insurance so that if your portfolio goes down, the puts increase in value and offset some of your portfolio losses. You could also bet against stocks that you believe would suffer because of the pandemic with put options or bet on stocks that would benefit from the pandemic with call options.
What I mentioned above requires a lot of experience and knowledge and may not be easy to implement for the average investor.
I found it easier and less stressful to only invest with idle cash that I do not need so that I would have holding power to ride through any market turbulance. I also keep a small war chest of idle cash that I can choose to inject into my investments when there's an opportunity to buy stocks on a much cheaper price.
I want to grow my investment portfolio
Diversifying your investments can help your portfolio grow.
Does this statement sound illogical to you? Let me explain why.
By diversifying the equities portion of your investment portfolio by investing in a number of companies or asset classes that you are confident in, you just need 1-2 of them to experience massive growth and 10x your investment and your portfolio would be considered pretty good for the year.
For example, seasoned stock pickers who have picked Tesla and Sea among the 10 stocks they invested in last year and the massive growth would have created great returns for their portfolios.
Some investors who have diversified a small portion of their investment portfolio into megatrend ETFs like ARK Genomic Revolution ETF or cryptocurrencies like BItcoin or Ethereum would also have added amazing returns into their overall portfolio.
In my case, by staying invested in ETFs that are diversified across 1000-10,000 companies across the globe and injecting more idle cash into the portfolio when the market was down allowed me to capture those gains and grow my investment portfolio.
Common rookie mistakes in building a diversified portfolio
Having a diversified investment portfolio is probably the most common advice given to beginners who are new to investing. But I found that there is a lack of follow-up recommendations on how they could accomplish that.
As a result, these beginners end up building an investment portfolio that they thought to be diversified, when it really wasn't.
Here are some of the common mistakes that I see some investors make when they just started to learn how to invest.
Investing on similar portfolios on multiple platforms
Investors today are spoilt with the wide variety of products and platforms available in the market for them to invest from.
The benefit of having many choices can be a double edged sword as well because having too many choices could lead to decision paralysis.
When overloaded with too many choices, investors tend to perform one of the options below:
- Choose not to invest at all because it's too complicated to make a decision.
- Make snap judgments just to avoid the hassle of navigating through all the confusing options to find the best decision.
- Deciding to split their capital and invest in a few options that offer the same thing to see which works better.
For options 1 and 2, the results are obvious.
The investors who went with option 3 often have the wrong impression that they have diversifed and made safe bets. For example, I know of a number of investors who wanted to avoid understand how all the various robo-advisory investment platforms like AutoWealth and Endowus work and they eventually decided to invest in 2-3 robo-advisors, choosing similar risk profiles to set up their portfolios.
The problem with this is that while the portfolios are fairly similar in the risk profiles worded on the platform, the underlying funds that these portfolios invest in can be drastically different and that results in differing performances in the market over time.
Because these investors don't understand what are the underlying funds of each portfolio and how the investments were made, they wouldn't be able to tell at the end of the day, which portfolio performed better.
Tip from Mickey: Without knowing how your portfolio is invested, How would you know if which portfolio is generating the best return at a risk level that you can accept?
Investing in ETFs that are recommended in forums and blogs without doing any research
Many new investors think that a diversified investment portfolio simply means investing in a few stocks/funds or asset classes, especially after reading a few blog articles by financial bloggers that recommended investing in certain ETFs for a diversified exposure to their portfolio.
However, the devil lies in the details.
Let's take a popular ETF, iShares Core MSCI World UCITS ETF (IWDA) that's often recommended in Hardwarezone forums for example.
The name of this ETF may give you the impression that you will be well-diversified 'all over the world' if you invested into this ETF. But 'all over the world' may be different to how you interpreted it.
Let's take a closer look at the iShares Core MSCI World UCITS ETF.
While the name of the ETF can make one think that he/she is investing in a globally diversified ETF, a quick look at the geography exposure breakdown in the iShares website shows that two-third of the fund is invested in United States while the remainder are invested in a number of developed countries.
There's no investment made in developing countries, including China.
If they were expecting to be able to capture some of the gains from Chinese tech giants like Alibaba and Tencent, it's not going to happen with this ETF.
Tip from Mickey: It's super important to dig deep into each stock and fund in the portfolio to understand what they are focused and investing in. That ensures that you are building an investment portfolio that meets your objectives.
Diversifying into different asset classes with highly positive correlation
The idea of diversifying your investment into different asset classes can be very useful if you want to taper down the volatility of your investment portfolio.
But that only works when you have a good understanding of the asset classes' correlation against one another.
Here's a historical correlation chart from Guggenheim Investments.
When my friends who have just started investing showed me their investment portfolios, one of the problems I often see is that while their portfolios seem to be well-diversified across different asset classes, they were actually rather concentrated from a correlation point of view.
For example, one of their portfolio had 30% in bonds, 20% in Vanguard S&P 500 ETF (VOO), 20% in IWDA ETF and 30% in Singapore REIT (S-REITs) stocks. While the portfolio may look diversified just look at the above breakdown, we need to remember that a portfolio is only well-diversified if it suits the investor's risk appetite and objectives.
For this friend, his appetite for risk is low and he wanted to keep his investments safe and defensive.
When I explained the breakdown of his portfolio to him in detail, this 'diversified' portfolio no longer seem diversified anymore because both the VOO and IWDA ETFs were highly correlated due to the heavy exposure to the US market in their funds (remember I mentioned earlier that 67% of the fund is invested in the US market?) and he was not interested in being overly exposed to the US market.
What he didn't know was that S-REITs have a high positive correlation with US and global equities and that means his S-REITs, VOO and IWDA ETFs would move in the same market direction. He was expecting his S-REITs stocks to remain flat-ish and defensive in the bear markets, collecting dividends along the way.
With all 3 components of his portfolio that forms 70% of his overall portfolio moving in the same market direction, the portfolio is more volatile (aka risky) than he expected, even though the portfolio was generating more returns today in the bull market.
Tip from Mickey: Correlation of asset matters. It's important to understand how each asset and asset class correlate with your existing portfolio before adding them to ensure your portfolio maintains your preferred level of volatity.
Overestimating your portfolio's diversification
Let's take the Straits Times Index (STI) for example.
Many new investors including me started their investing journey by investing in one of the STI ETFs available in the Singapore Stock Exchange.
I used to invest in the STI ETF that tracks the Straits Times Index thinking I'm investing into the Singapore economy (I was really new to investing at that time). So as long as Singapore does well, my portfolio would do well.
But in reality, the index invests in the top 30 companies listed on SGX in a market capitalisation weighted manner.
The STI would allocate a larger percentage of the index to companies with larger market cap. That means if the total market value of a company's outstanding shares is higher, it'll get a higher weightage in the STI index. A company with a larger market cap usually means that it's a larger company and is more well-established.
These companies are often also more expensive because they would have a higher valuation priced into its share price when compared to companies with smaller market cap that may be more attractively priced. That means when you invest in a market capitalisation weighted index like STI that only has 30 stocks, a larger percentage of your money is being invested in expensive stocks with high valuations.
At the same time, because the STI only consists of 30 stocks and close to 40% of its weightage is in the 3 major banks in Singapore. While you may think that you are diversifying your investment when buying the STI ETF, your portfolio are actually very concentrated on the financial sector. If major financial crisis happens that impacts our banks, your portfolio will take a big hit even though companies from the other sectors in the STI index were not impacted.
Tip from Mickey: Just because you're building your investment portfolio by investing in an index, doesn't mean that your portfolio is diversified. You need to examine what stocks do the index consist of and the weightage of each stock in the index before deciding if it is suitable for your portfolio.
How do you avoid making these rookie mistakes?
It sounds like I'm bashing rookie investors but truth be told, I have made these rookie mistakes myself too when I started investing many years ago and I learnt this mistakes the hard way - with money.
Through my investment jouney, I've learnt that there are a number of ways to diversify your investment portfolio so you can easily mix and match on your own to create your ideal definition of diversification.
Stay tuned for my next article where I'll share some of the options you could consider when diversifying your investment portfolio.