Making money in the markets has rarely been this easy as it has in the past nine years.
Index investing has seen momentous success in the last decade, which leads to huge amounts of money flowing into the markets in a mechanical manner. The global economy settles down in a “Goldilocks” state; inflation stays low while we witness a rare sustained synchronized upswing in major economies. Finally, major central banks around the world provide a safety net for investors with their accommodative monetary policy.
The above factors combined to bring about persistently low levels of market volatility, and one of the greatest and longest ever stock market bull runs. Since losing 38.5% in 2008 in the outbreak of the global financial crisis, the S&P 500 almost tripled in the following nine years as it closed at 2673.61 on 29 Dec 17. The global All Country World Index (MSCI ACWI) posted a 125% gain during the same period.
At the same time, various indicators of investor sentiment seemed to point towards a future where nothing can possibly go wrong. For example, in a six-month period through late November, the CBOE Volatility Index (VIX)—commonly known as the “fear index”, VIX indicates the volatility expectations of investors based on their pricing of S&P 500 options—closed below a reading of ten on more than 40 days. According to a New York Times article, it had never done so more than six times in any six-month period before that.
The benign investing environment might have lulled investors into complacency and made them vulnerable to an unforeseen shock. And after the unusual tranquility of last year, the early months of 2018 have seen the return of volatility with a vengeance (see Chart 1). Year-to-date April, the S&P 500 lost 1.0%, while the MSCI ACWI ended 0.7% lower.
Chart 1: Volatility returns in 2018
A few developments contributed to the larger price movements. Higher inflation expectations caused a sudden spurt in Treasury yields since the start of this year. The likely exit in the near future by several systematically important central banks from their loose monetary policy also led to a reprice of risk-free rates. The increased trade tensions, China deleveraging, and geopolitical uncertainties round up the list of potential threats that could derail the bull party.
The resetting of markets serve a good reminder of how difficult it is to time markets. While on hindsight it is easy to say that valuations most everywhere were rich and uncertainties abound, we could have made the same points since a few years back. Investors who have gone full-defensive and refrained from bearing any risk for the last few years would have paid huge opportunity costs.
But on the other hand, we think reaching for returns (by investing fully in high-risk assets, for example) and trying to get out near the peak would have been a bigger mistake when risk tolerance was high and prospective returns low in the markets. The right approach for investors, we propose, is to (i) gauge the market temperature regularly to decide the right place between maximum aggressiveness and maximum defensiveness; and (ii) stick to proper portfolio diversification and allocation. This article considers the importance of the second point.
Risk vs return: the intractable investment problem?
Each and every one of us face this dilemma when we make an investment choice. Do we take on riskier investments in pursuit of higher returns? Or do we lower our risk—usually defined as the volatility of the investment—and settle for ho-hum but acceptable returns. This conventional relationship between investment risk and return is depicted in Chart 2.
Chart 2: Risk and return
This widely accepted concept that low risk and high returns is at odds with each other is one of the key principles underlying the famed capital market theory. But what if we refuse to settle for the easy answer and seek to earn higher returns without taking on higher risks? Billionaire investor Ray Dalio, founder of Bridgewater Associate, the world’s largest hedge fund (according to Investopedia.com), says we can.
The Holy Grail of Investing
As described in his 2017 book ("Principles: Life and Work"), Mr Dalio found out from his earlier failures that proper diversification was the cardinal feature of all successful investment plans. To understand diversification in a simpler way, Mr Dalio (with the help of his staff) did a chart to show how volatility would decline and risk-adjusted return improve as investments with different correlations are incrementally added to a portfolio. The resulting graph looks something like Chart 3.
Chart 3: The Holy Grail chart
Mr Dalio wrote in his book that the chart struck him with the same force he imagines “Einstein must have felt when he discovered E = mc2.” He realized that by building a portfolio filled with 15-20 high-quality return streams that were exposed to different risk factors, i.e. have low correlations, he could dramatically reduce risks without sacrificing expected returns. Mr Dalio called this principle the “Holy Grail of Investing”, and said it’s the secret behind Bridgewater’s success.
While many of us probably understand intuitively the benefits of having multiple uncorrelated return streams vs having just one, Mr Dalio argued that even most professionals are not managing their investments properly. We tend to diversify our investments across only a single asset class, which are generally highly correlated with each other. As Chart 3 shows, we could spread our money across a thousand 60%-correlated shares and the risk-adjusted return wouldn’t be much different than if we had picked only six.
In the later sections of this article, we will examine the tremendous portfolio benefits of adding just one asset class to a stock portfolio. But before we begin to do that, we can imagine some objections surfacing at this point of time. Most likely it would be along the lines of: “Why should we care about price fluctuations when equities, as shown by history, are virtually certain to outperform bonds in the long run?”
In the long run... we are all dead
To answer the above question, let us time travel back to 1928, and imagine that we have placed our entire savings into the US stock market. If we had adhered rigidly to the advice of ignoring market fluctuations and stayed 100% in equities, this is what would have happened.
Chart 4: The problem with 100% equities
The Dow Jones Industrial Average (DJIA) lost 89% of its value within three years in the Great Crash of 1929. As with most other market cycles, these losses did eventually recover. But let us take a guess at how long it took for DJIA to return to its peak in 1929.
The answer is 25 years, in 1954. That is how long it took for the US stock market to recover from the Great Depression. How many of us can honestly say that we will not bail out on a money-losing strategy for 25 years?
Now, we have purposely used a doomsday scenario to bring out our point, and it is probably unwise to base our investment strategy on the greatest stock crash in US history. But the fact remains that many of us underestimate the pain of losing a large chunk of our net worth. Yes, a 100%-equity portfolio is likely to earn higher absolute returns than a balanced portfolio in the long run, but we could go broke in the short run.
The benefits of portfolio diversification: an illustration
As demonstrated by the Holy Grail chart, adding good uncorrelated return streams to your investment portfolio is the surest way to enjoy most of the upside without being exposed to unacceptable losses. And if we reject the myth that investors were objective automatons who could brush aside short-run losses with total disregard, we need to start paying more heed to the importance of portfolio stability in terms of investor behavior.
As an asset class, bonds especially investment-grade bonds have very low correlation to equities, meaning their returns tend to fluctuate in different directions. This characteristic provides tremendous diversification benefits, smoothing out the large volatility in an all-equities portfolio.
Figure 1 shows the 30-year historical total return (December 1987 - April 2018) of MSCI ACWI versus a theoretical balanced portfolio divided equally between MSCI ACWI and the JP Morgan Global Aggregate Bond Index. The two-asset-class portfolio cut a large chunk of the volatility while sacrificed little in the way of returns. The return-to-risk ratio of the balanced portfolio is more than 50% better than the all-equities portfolio. Also, during the worst year in 2008, global equities lost ~42%, while the balanced portfolio lost less than half as much.
Figure 1: Historical performance (in USD) of global stocks vs a balanced global portfolio
Figure 2 tells the same story, just in the local context as we have replaced the benchmarks with Singapore indices—the MSCI Singapore Index and iBoxx ABF Singapore Total Return Index. Again, a balanced Singapore portfolio would have delivered superior risk-adjusted returns. The worst year for both portfolios was (again) 2008, when Singapore-listed shares lost about 47% (in total return), while a balanced portfolio lost ~27%.
We think it bears reminding that it is one thing for us to look at the 2008 crash on paper, and another for us to actually live through it. It is like reading about tornado in a book and actually being swept by one. To prevent us from having knee-jerk reactions to market corrections and abandon the markets altogether, we need to add more high-quality and uncorrelated asset classes to our investment portfolio.
Figure 2: Historical performance (in SGD) of Singapore-listed stocks vs a balanced Singapore portfolio
Start diversifying now
There are many ways FSMOne can help to start your journey in constructing a properly diversified investment portfolio. We list three of them below. If you are still unsure, the easiest way would be to reach out to FSMOne’s team of friendly advisers. Whether you are a new investor, or simply need a second opinion on your current portfolio, feel free to contact FSMOne’s Investment Advisory Team.
Bonds
FSMOne provides one of the largest bond offerings in Singapore. In addition to that, the platform also has innovative tools and independent research analysis to equip you with the confidence and knowledge to plan your investments. You may refer to “Bond Insights” and “Bond Issues” for our credit coverage and recommendations. In addition, our Bond Selector tool provides a convenient way to filter for the appropriate list of bonds for your portfolio.
Funds
For those of us—including this author—who wish to add bonds to our investment portfolio, yet do not have enough capital to construct a well-diversified bond portfolio, we may start by investing in bond funds. A good starting point for this route will be FSMOne’s Recommended Funds Report. FSMOne’s team of analysts have done their homework to handpick a lineup of recommended funds in each category based on a list of criteria (e.g. performance, expense ratio, investment approach), so that you don’t need to spend your precious time looking through the huge array of options available on FSMOne.
But why stop at bonds? Investors looking to invest in commodities, currencies or other alternative asset classes can use FSMOne’s Fund Selector tool to search for the suitable funds.
My Assisted Portfolio Solution (MAPS)
MAPS is FSMOne’s online portfolio management service that helps you invest in a portfolio of unit trusts and ETFs. You are able to choose between five portfolios depending on your investment objective and risk appetite. The portfolio managers of MAPS make their investment decisions through a systematic process based on valuation and in-depth research. With as little as S$1,000, you can gain access to a well-diversified portfolio of funds, chosen by FSMOne’s professional managers so that you can have time for the more important things in life.