Diversification: It Is Not A Competition

My Investment Analysis lecturer always repeats the following mantra. “When you speak about investment, concentrate more on risk and less on return.”

The common mistake we tend to do is to seek for investment instruments with the highest return. We then proceed to invest in them without taking any consideration of the purpose or risk associated with these assets. We treat this comparison as competition and conclude the one with the higher return is the better investment.

All these can be true until you face a systematic downturn as we are facing now with the COVID-19 pandemic. High-risk investments such as equities are performing poorly compared to low-risk investments.   

If your investment objective is for the long term, chances are you can withstand the short-term market volatility. However, if your investment time horizon is getting closer to your objective but you are now forced to face the reality of a market downturn, what would you have done differently to mitigate your risks?

Diversification

Due to the uncertainty nature of markets, the common method to reduce investment risk is through portfolio diversification. This can be done by diversifying our investments mainly across sectors, regions or asset classes with different risk categories.

The goal of diversification is to:

1. Manage or reduce overall portfolio risk

2. Reduce concentration into one or limited asset classes. As the saying goes “don’t put all your eggs in one basket”.

3. Ensure multiple streams of income.

4. Achieve a consistent return.

Infographic designed by Carl Richards aka The Sketch Guy made available on his site Behavior Gap. 

As shown in the above infographic, diversification helps to balance one’s investment portfolio. Yes, you may not observe high returns in the short term but diversification ensures your investment portfolio is not exposed to major losses during a market downtrend.

How Does EPF Diversify

We Malaysians are fortunate to have the Employees Provident Fund (EPF). For most of us, 23% of our monthly income (11% employee’s contribution plus 12% employer’s contribution) is invested in EPF investment for our future retirement needs.

The yearly dividends paid out by EPF is commendable and consistent across the years. To understand how they achieve this, let’s dissect how EPF diversify their investment portfolio by referring to the information shared here.

Diversification Across Regions

Prior to the 97/98 ASIAN crisis, EPF was allowed to invest only in Malaysia. After the crisis, they realize they can no longer depend on one country to provide consistent returns. Since then, EPF has diversified 30% of their investment outside of Malaysia.

Diversification Across Asset Classes

EPF investment can be considered as a balanced or mixed asset investment. They have diversified their risk across several asset classes. Equity has the highest risk, followed by real estate, fixed income, and money market. Since fixed income allocation is at 49%, close to half of the asset allocation, we can consider EPF’s investment strategy as safe or conservative. This is a useful strategy especially for retirees seeking income.

Diversification Effect on Income

Below is a diagram illustrating EPF’s 2018 and 2019 income.

2019 year over year (YoY) observation:

1. Income from equities declined by 24% (RM 26.66 billion to RM 21.49 billion) , but

2. Income from fixed-income grew by 17.7% (RM 16.64 billion to RM 19.60 billion).

3. Although income from equities declined (RM 21.49 billion), it still generated a higher income compared to fixed income (RM 19.60 billion).

4. Overall, the total income declined by 5.4% (RM 43.30 billion to RM 41.09 billion).

Noticed how the investment allocation into equities (39%) is lower than fixed income (49%) but equities manage to generate a higher income. This is a clear example of high risk, high return investment.

Having said that, what do you think the total income would be if EPF had invested only into equities? It’s hard to predict this but since the income from equities declined by 24%, I can only assume the total income would have been lower than RM 41.09 billion. In this case high risk, high loss.

Anyway, the main point here is that EPF doesn’t depend on one stream of income. Although they are conservative, they have investments in higher-risk assets too. They have diversified their risk, not to generate the highest return but to generate a consistent return.

Diversification Analogy

To understand the concept of diversification better, imagine in a household the husband is running a business, while the wife is an employee for an organization. We know running a business is way riskier, but it has the potential to generate a higher income compared to a steady income earner.

During good days, the husband’s business will provide most of the income for the household. However, during bad days, the husband’s business will be hit hard and may fall back to the wife’s steady income to sustain the household.

In this case, the husband’s business can be considered as an equity investment while the wife’s income is a fixed income investment. They are not competing against each other, instead, they are working together by diversifying their risk to generate a consistent income.