Diversification Headache (29 June 2009)

It is getting harder to diversify these days. It used to be that the correlation between various region’s stock markets was lower. So, if you had a global portfolio, it was considered pretty well diversified. Many fund managers in the US did not even have any concept of investing outside of US as little as ten years ago.

As the year 2008 showed, these days, when there is a crisis, it can easily go global, and when it does, there is almost no place to hide in stock markets. That makes having a global portfolio no longer enough for diversification. Now, it is quite important to have asset classes other than just being in stock markets if you want to diversify properly. This is why even though I consider myself an “aggressive” type of investor, I still hold bond funds.

Within bonds, I am actually not that keen on the bond funds holding lots of G7 government debt. Interest rates are already so low, if I really wanted that kind of safety over anything else, I might as well stick to the cash fund. Emerging market and high yield bond funds give me a much higher yield, and they will also be beneficiaries of a global recovery, which I am positioning my portfolio for.

However, this also means that they also cannot completely diversify away risks in my portfolio. Only things like SGS bonds, Singapore bond funds and money market funds like the cash fund can provide that kind of safety to allow us to diversify out of equities effectively. Their returns though are relatively low at this point.

Nevertheless, every little bit helps. An un-hedged, totally one sided portfolio that is totally banking on the Asian economic recovery is going to be high risk, and very volatile. It may not be everyone’s piece of cake. So, while the thought of holding anything like cash fund or bond funds might seem too boring and delivering too low a “return” for many. The alternative, after seeing the swings that equity markets went through from last year till now, is likely to be unappealing to many investors as well.

Just remember, the key objective of diversification isn’t to improve your return, its to lower your risk.