03 Jan At loggerheads: Home market bias and diversification

Most of us invested in Asian markets are happy campers! Asia x Japan is up 37% in US Dollar terms in 2017, which is 2x the performance of US Equities. So this particularly is a bad time to talk about diversification and more so diversifying away from our home markets in Asia.

Though this is a great time to preach benefits of diversification in developed markets!

We all know diversification lowers risk. All this sounds nice in theory, but we see very little of that implementation in real life. Home market bias is real and permeates across all types of investors, individuals and institutions. Such biases are further cemented in times such as these when the home markets have outperformed all markets and that too by such stellar margins.

The power of diversification

Diversification brings two advantages. On the one hand, it provides with an opportunity to invest in more performing securities. Think about emerging markets for a US-based investor as an example.

On the other hand, it mitigates what is commonly referred to as idiosyncratic risks, or risks that are specific to one geography, sector or asset category. With diversification, idiosyncratic risks become near irrelevant. As these risks only influence the price of one security or asset class, they will have a very limited impact on the whole portfolio. This leaves the portfolio only exposed to systematic risks, or risks that are common to the whole market.

There are several ways to diversify a portfolio. We can invest in different stocks, but also diverse types of securities, geographical areas, company sizes or type of issuer. The key concept is to invest in various baskets that are not influenced by identical factors and thus do not move together in tandem.

As an example, let us assume an investor (Ms. Chan) who has a large exposure to Singapore stocks. We explore the benefits, numerically, of adding diversity to Ms. Chan’s portfolio who obviously suffers from a home market bias.

Although her investment has not fared too badly since the STI index has edged up 5% per year on average over the past 15 years, it could have greatly benefited from being diversified.

The chart below compares the performance of a portfolio only invested in the STI (the yellow dot) and various other portfolios invested in different asset classes over the last 10 years.

As we see from the chart above, Ms. Chan’s portfolio (yellow dot), fully composed of the STI, exhibits the worst 10-year performance for the highest risk. On the contrary, the diversified portfolios show increasing returns as we keep adding asset classes, while the risk substantially lowers. Thus, as a portfolio gets increasingly diversified, it increases its risk-adjusted return and moves towards the top-left corner of the chart.

Another interesting chart is the one below, which maps the same portfolio’s total performance and maximum loss over the last 10 years.

We can see that the maximum drawdown, or the maximum loss that the portfolio has (potentially) incurred over these 10 years, is drastically reduced from 62% for the single asset-class portfolio (Ms. Chan’s) with only Singapore stocks to 35% for the portfolio with 6 asset-classes.

Therefore, this validates the idea that diversification comes in quite handy for:

  • Limiting the downside risk of the portfolio
  • Reducing the volatility of the portfolio
  • Improving the portfolio’s performance

As a case in point, Ms. Chan has investments only in local Singapore stocks, however this applies to each and every investor worldwide who stay within the comfort zone of domestic stocks.

The benefits of diversification are the basis of one of the best-known portfolio management theories. In 1962, Dr. Markowitz presented the Nobel Prize-winning Modern Portfolio Theory that states there exists an efficient frontier that includes all portfolios maximizing returns given a certain level of risk.

Correlation

Diversification works as asset classes don’t move in tandem. The chart below shows the low correlation Singapore Equities have with asset classes such commodities and European Equities, while having high correlation with Asian Bonds.

Further, the correlation between asset classes tends to strengthen when volatility rises. Thus, it is critical to frequently revisit correlations across asset classes when considering portfolio allocation and adjust to forward looking market expectations.

The payoff

Most of us are aware that diversification is key to portfolio management. However, sometimes we choose to remain attached to our home market, which is a solution of comfortability and simplicity but not of efficiency.

The chart below says it all: since 2007, if an investor had invested equally in the S&P 500 and the Straits Times indices rather than the STI only, she would have improved her portfolio’s performance by 33%.

Diversification for STI

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