You have been doing diversification wrongly. Find out why.

Ng Chun Hou, Associate Director of LFA recounted that one of his clients’ most common misconception was that diversification is easy. ‘They all knew not to put all their eggs in one basket. But as we delved deeper into our portfolio allocation discussions, we realised that there was a gap in understanding what good diversification truly meant.”

“I recall one client who told me confidently that his portfolio was well-diversified. He owned different SGX stocks from non-overlapping industries, and saved his money across different banks. However, he did not own any bonds, mutual funds, or global stocks. Most of his SGX shares are also blue chip stocks.”

According to S&P Global Market Intelligence, the top three industries most affected by COVID-19 are airlines, leisure facilities, and oil and gas drilling. The top three industries least affected are specialised REITS, property and casualty insurance, and multi-line insurance.

With this in mind, if you own stocks from all these various industries, and perhaps a few more from the healthcare services or fintech industry, surely, you should be sufficiently diversified, right?

Wrong.

Diversification is multi-faceted

Diversification spans not just across industries and geographical areas, but also asset classes, risk levels, investment needs, and time horizons or holding periods, just to list a few. Even within the category of mutual funds, which is a type of investment instrument that spares you the pain of picking individual stocks, you can choose amongst growth funds, income funds and balanced funds.

There is also a need to ensure that you do not diversify excessively since “over-diversification is a hedge for ignorance”, aptly put across by William O'Neil, an American entrepreneur and stockbroker.

By ensuring that your portfolio is well diversified, you can better buffer against market shocks. 

In a study of average portfolio returns and volatility for almost 90 years from 1926 through 2015, it was concluded that diversification is a means to smoothen out market swings and minimise losses without significantly diminishing long-term returns.

However, it is important to note that diversification does not make your portfolio immune to all market shocks. Short-term losses are definitely likely. In the study, even conservative portfolios suffered a loss of about 17% during their worst 12-month period nosedive.

Another drawback of diversification is that it limits your returns to the ‘average’. By being exposed to multiple firms and types of investments, you are hoping to emerge with more winners than losers to average out the volatility. However, by design, your gains will also be averaged out. The good is, of course, that you will see fewer massive downturns as opposed to aggressive portfolios that are heavily concentrated in equities.

Diversification can also be a costly and time-consuming endeavour. You need to take the time and effort to research and sieve through possibly dozens or hundred of stocks and bonds. Buying these various investment instruments is not only expensive for the individual investor, but can also leave them paralysed with choice.

The paradox of choice

When you are overloaded with too many options, you experience a state of overchoice. 

Barry Schwartz studied how having more choices does not lead to better decision making and can conversely make us feel worse about what we got, even if it was great. The reduced satisfaction can arise from many factors, not limited to the escalation of expectations, opportunity cost comparison, regret, and self-blame. Overchoice is also associated with unhappiness, choice deferral, decision fatigue, and the avoidance of decision making altogether.

Map detailing antecedents and consequences of choice overload (Journal of Consumer Psychology, April 2015)

To illustrate the above, picture this common investment scenario. When having a huge pool of stocks to choose from, you often end up being unable to decide. You may have raised expectations while looking at the buffet of options, and start to meticulously calculate the individual opportunity costs of investing in many of the options. You may also try to forecast your anticipated regret if you were to choose option A instead of B, C, D, E, F and so on.

This cycle of decision making can last for numerous rounds, until you finally choose to not buy anything. If you were to buy a few stocks from the initial pool, you may end up blaming yourself if you did not pick the highest performing stock on hindsight.

Even if you have decided to make monthly, fixed contributions to funds to tap on the magic of dollar cost averaging, there is still a need to select the funds that best match your financial goals.

Often times, investors may also face a lack of time or knowledge, uncertainty in investment preferences, time constraints on the return horizon, and many other factors.

Filter out suitable investment gems

To aid you in making confident choices amidst the sea of investment options available, it can be reassuring to engage the help of a professional financial advisor.

LFA provides a Discovery Meeting to, as its name suggests, discover your values and motivations to find out what truly matters to you. By discussing at length on what you want, you get to paint a clearer picture of how you want your life in the next five, 10, or 20 years to look like. With that in mind, LFA can then recommend suitable investment portfolios and go through how they can help you achieve your financial goals at various life milestones.

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