Is diversification a good strategy to minimise investment risks?
Oftentimes, we have heard the preaching of ‘Don’t put all eggs into one Basket’ when investing our money. The logic is to lower our proportion of wealth lost in the event of one failed investment by having a diversified investment portfolio.
In this article, I’ll expound my views on diversification, discuss its effectiveness in minimising risks of investing and finally, end it with a few key notes on what I’m practising now to address these investment risks for my own portfolio. Here, I’ll start off by defining two types of risks: Non-Systemic Risk and Systemic Risk.
What is Non-Systemic Risk?
Let’s say, we have A Ltd, a media conglomerate that owns satellite TV and Radio Stations in a nation. Despite being a leader in its industry, its business had been impacted by the rising trend of social media such as Facebook, YouTube, Netflix and so on and so forth. With declining advertising profits, A Ltd’s stock price fell by as much as 70% from 2015-2020.
Meanwhile, the other stocks listed in the nation were not impacted by A Ltd. As such, the above illustrates what non-systemic risk is. If a person had made all of his investments in A Ltd, he would incur huge losses. Hence, the above explains why stocks are viewed to be risky investments and why diversification or having a diversified portfolio is recommended to reduce the above risk.
So, does it help? Well, before I answer, let’s look at:
What is Systemic Risk?
There are many examples of what systemic risk is and the latest addition to it is the COVID-19 pandemic. During the period, jobs were lost, pays were cut, loans were on moratoriums, businesses slowed, borders shut, travels were restricted, interest rates slashed and so on and so forth. It is both a nationwide and as well as a global issue. Everyone is affected and impacted by it.
Thus, we witnessed an acute crash in stocks worldwide in March 2020. That is a systemic risk.
Is Diversification the Answer to Reduce Investment Risks?
Sure, you could be superbly diversified with 30 stocks in 15 different industries, a handful of unit trust funds, ETFs, REITs, Index Funds and Robo-Advisory Funds in your investment portfolio. Here, I like to ask: ‘Was your portfolio spared from the acute crash in March 2020? What is the difference in performance between your well-diversified portfolio with another who has 5-10 stocks which are solid fundamentally in his or her portfolio?’
My hunch is that the outcomes between the two are more or less similar. Why? This is because everything (I mean, almost) crashed in March 2020. In fact, your well-diversified portfolio is not exactly diversified because stocks and the rest in the portfolio (unit trust, ETFs, REITs, Index Funds, and Robo-Advisory Funds) are paper assets where most of them (except REITs) invest in the stock market.
So, I’d learnt that diversification alone (especially among different paper assets) is ineffective to reduce both non-systemic and systemic risks when investing my money. Hence, I began to explore other methods to minimise both risks so that I can build myself a portfolio that is not only profitable but also sustainable and resilient against political, economical, and pandemic crises.
Here are some stuff that I work on to manage investment risks:
1. Performing ‘Credit Assessments’ on Stocks
In my last letter, I described the job of an investor as being similar to a banker.
As a recap, if a banker minimises his risk of a potential loan default by assessing the credit of his borrowers, likewise, as an investor, I would be seeking to lower non-systemic risk by performing credit assessment on a stock before investing.
How to do that?
Personally, I would vet through each stock with the 2-Step Funnel below:
Step 1: The Business I Like to Keep
The stocks should fulfill all of the following criterias:
a. Have a Resilient Business Model that Generates Recurring Income.
b. Delivered Consistent Growth in Revenues and Earnings for the last 10 Years.
c. Generated Positive Cash Flows from Operations for the last 10 Years.
d. Have a Strong Balance Sheet. Low Debt and High Current Ratios.
e. Revealed a Concrete Plan towards Sustainable Growth in the Future.
Step 2: The Price I Like to Pay
This would involve the art of stock valuation. Ideally, my preference would be:
a. Preferably Below 20. Ideally 10-15 or below 10 would be awesome.
b. Current P/E Ratio < Its Long-Term P/E Ratio Average.
c. Dividend Yield above FD rates. Ideally, 4%-6% would be awesome.
d. Current Dividend Yield > Its Long-Term Dividend Yield Average.
That is my way of tackling non-systemic risk. But, what about systemic risk?
2. Cash-to-Stock Ratio
This really depends on one’s current financial status and preference.
As for myself, I aim to keep a high cash-to-stock ratio of 1.5-2.0 at all times. This means I intend to keep $1.50-$2.00 in cash for each $1.00 in today’s stock value of my portfolio. For instance, if my stock portfolio is worth $100,000 presently, I would aim to keep $150,000-$200,000 in cash as reserves.
Why? This is because, let’s say I have $100,000 in stocks and $200,000 in cash:
a. Stock Portfolio Falls in Value (Systemic Risk)
If my portfolio drops in value by 50% to $50,000, I’m still okay as I hold a sizable amount of wealth in cash. As a matter of fact, I could invest some of the cash to either buy more shares of stocks I have invested in the past or to acquire myself new stocks that I have been aiming to own at hugely discounted prices.
b. Stock Portfolio Goes Up in Value
If my portfolio goes up in value by 50% to $150,000, that’s great. But, this could also mean that the stock market is becoming more overvalued, not a climate to acquire new stocks. Hence, I would choose to increase my cash reserves so that I can maintain the cash-to-stock ratio at 1.5-2.0. In a way, the ratio prevents me from buying stocks when their prices are rising.
3. The Ultimate Portfolio Diversification
Finally, as much as I like stocks, I don’t foresee myself emptying all my money in my bank accounts to buy stocks. Personally, I prefer a balance approach where I would spread my portfolio into 5 different types of asset classes:
a. Business: to derive active or semi-active income.
b. Real Estate: to use leverage to compound net worth over time.
c. Stocks: to store wealth in multiple currencies while earning dividend income.
d. Commodities: to hedge against inflation.
e. Cash: to act as a reserve fund and to pay bills.
So, I believe each asset class has their place in building our wealth and this will require us to remain a student as we become a lot more all-rounded in all asset classes so that we could tap into their best to achieve our financial aspirations.