wealtharticles-a_well-diversified_portfolio_=_healthy

A well-diversified portfolio = healthy investments

Having a well-balanced diet, containing the right combination of all the major food groups, goes a long way in sustaining one's health. In the same way, having a well-balanced investment portfolio improves the chances of garnering healthy returns in the long run. In fact, a study has shown that asset allocation determines 40% - 90% of investment returns.

While it is our responsibility as financial planners to help clients determine an asset allocation strategy - at a high level -that suits them, should it be our responsibility to select the underlying securities in the portfolio?

The financial planner's role is to provide clients with quality financial advice, helping them achieve their lifestyle goals. This begins with understanding the client's objectives and the returns required to achieve those objectives, which would then determine the asset allocation strategy required to achieve those returns. There is a risk that accompanies this asset allocation strategy and if it is a risk the client is unable to stomach, the financial planner and client need to re-look at the objectives and make some trade-offs.

We do not believe that it is the financial planner's role to construct portfolios, as it should be handled by the investment team. However, it is important that financial planners understand how it is done, why diversification is important and how diversification can impact the performance of a portfolio.

Asset Allocation
What constitutes a well-balanced, well-diversified portfolio? It is more than just investing in as many different products as possible. Very often, the end result is a small combination of asset classes, with each having common characteristics.

There are four basic asset classes: cash, bonds, equities and properties-all of which have different potential returns over time with corresponding risk levels (see Table 1).

An Efficient Portfolio
A portfolio that minimizes portfolio volatility for a given expected return is said to be efficient.The efficient portfolio joined together for a given set of investment alternatives forms what is called the efficient frontier.

An inefficient portfolio has financial implications in the future. The examples below illustrate the opportunity gap in non-efficient portfolios. The opportunity gap is the difference in return between the efficient portfolio and the random portfolio. Financial planners need to understand that diversification not only reduces volatility but can enhance returns for a given level of risk tolerence.

The second row of Table 2 shows a portfolio randomly generated with 40% placed in Singapore equities, 10% in Singapore Bonds and 50% in Global Emerging Markets. The mean annual return on this portfolio is 8.36% with a volatility of 14.1%. Had the portfolio been optimised for efficiency, the return would have been 9.1%. The difference between the mean annual return and the efficient return is the opportunity gap of 0.74%.

An excerpt from a book I authored, Make your money work for you - How to Grow Your Investment Dollars, explains how to diversify a portfolio:

Diversification: The Better Way
Harry Markowitz was the first person to formally show how portfolio diversification works to reduce portfolio risk. He showed how the inter-relationships between security returns - called correlation - could be used to diversify a portfolio so that risk is minimised while returns are maximised.

What is Correlation?
Correlation measures the extent to which the returns on two assetsmove together. If the returns on two assets tend to move up and down together, we say they are positively correlated. If they tend to move in opposite directions, we say they are negatively correlated. If there is no particular relationship between the two assets, we say they are uncorrelated.

The correlation coefficient is used to measure correlation, and it ranges between -1.0 and +1.0:

Corr   : +1.0 = perfect positive correlation
Corr   :   0.0 = zero correlation
Corr   : - 1.0 = perfect negative correlation

Understanding correlation helps us improve the diversification process of reducing portfolio risk:

Combining securities with perfect positive correlation with each other provides no reduction in portfolio risk. We should avoid securities that are positively correlated as the total risk is then higher.

Combining securities with zero correlation with each other does provide significant risk reduction, although portfolio risk cannot be eliminated completely.

Combining securities with perfect negative correlation can eliminate risk altogether.To see how correlation works, suppose you invest 100% of your money in banking stocks. As a group, banking stock returns are highly positively correlated. Good prospects in the industry will see the group rise as a whole. However, when prospects are poor, your entire portfolio will suffer as well.

In reality, securities typically have some positive correlation with one another. Although risk can be reduced, risk usually cannot be eliminated. As an investor, you should hence find securities with the lowest amount of positive correlation as possible.

Diversification Using Stocks and Bonds
One of the most effective ways to diversify is to invest in the two main asset classes of stocks and bonds because of their low correlation with each other. how much money should you allocate to each asset group?

The ideal asset allocation differs from person to person and is based on the individual investor's risk tolerence. A young executive typically has a higher riak tolerence than a retiree. The young executive, therefore, may have an asset allocation of 80% stocks and 20% bonds (since stocks are riskier than bonds), while the retiree may have a less risky allocation of 20% stocks and 80% bonds.

The idea is to mix and match stocks and bonds in a proportion that generates the highest return possible based on the amount of risk we are able to tolerate. In general, the higher our risk appetite, the higher the proportion of stock in our portfolio, vis-a-vis bonds.

By, Ben Fok, CFP

Asset Classes	Historical Long-Term Real Return (P.A.)	Risk Level	Riskof negative return over 1yr 5yrs 10yrs 20yrs
Cash Bonds Equities Properties	0 - 1% 0 - 3% 5 - 9% 1 - 5%	Very Low Low to Medium Medium to High High	n.a n.a. n.a. n.a. 2% 0% 0% 0% 25% 6% 2% 0% 14% 1% 0% 0%

Equity Singapore	Bond Singapore	Equity Emerging Markets Global	Portfolio Annual Return	Portfolio Volatility	Efficient Return	Opportunity Gap
30% 40% 50% 10%	30% 10% 40% 50%	40% 50% 10% 40%	7.08% 8.36% 6.10% 5.95%	10.90% 14.10% 10.10% 7.56%	7.60% 9.10% 7.20% 6.09%	0.52% 0.74% 1.10% 0.14%