Tuesday, January 15, 2013

Geographical Diversification, Part 1: A Second Look at Diversification


Dear Investor Juan,

Thank you for the very enlightening resource you've provided. I'm sure countless Filipinos will continue to benefit from your practical and approachable guides to investment.

On to my question. I've started EIP investments in the BDO Equity and Balanced Fund, but I'm worried that it might not be the best move considering the very high market at present. After reading about diversification, it seems that a genuinely diverse portfolio implies investing in not just one market, but in several.  In particular, the recommended portfolio from a US magazine for someone my age (25) was this:

80% Stocks
- 50% U.S.
- 15% Foreign developed
- 15% Emerging markets

14% Fixed Income
- 5% Investment-grade bonds
- 7% High Yield
- 2% Foreign Bonds

6% Alternatives
- 3% Commodities
- 3% Real estate

This brings me to a series of questions (apologies if some are a bit unrelated):
- Is the 50% US stock allocation due only to the location of the magazine? If so would it make sense to just switch Phil. Stocks with U.S. (i.e. 50% Phil, 15% US, 15% Foreign Developed)? Or is it truly better to follow the recommendation and put 50% in the US?
- If ETFs are locally unavailable, and I want to begin passive investing, what's the best alternative I can get? 
- What would be the best way to invest in foreign ETFs? A friend mentioned he opened an account with etrade in Singapore, but I'm not sure if that's the best way.
- I believe I've got the Fixed Income investments covered in my Balanced fund, but I'm curious to what those Alternatives really connote. 

Thank you so much and more power! :)


Dear Ayon,

Before I answer your questions, let's first take another look at diversification, which I discussed in detail in this post.

The objective of diversification is to manage risk, not minimize it. This means that in diversifying our investments, we should take the trade off between risk and return into consideration and allocate our resources in such a way that we meet our risk and return targets simultaneously. Done right, diversification should be able to provide lower risk given a particular level of return (or higher returns at a given level of risk) compared to specific types of investment, in isolation. This is achieved by investing in several kinds of investments or assets, whose returns are not perfectly correlated.

There are different ways of achieving diversification. Perhaps the most basic example is to invest in a portfolio of stocks, such as index or even actively-managed equity funds. Since component stocks of an equity fund presumably come from different industries, they are subject to different kinds of risks and their returns should therefore not be perfectly correlated. For example, some factors that negatively affect the business of Ayala Land would affect a company like Jollibee differently, perhaps even positively. There are some risks, however, that affect all stocks regardless of industry, and a 100% investment in stocks would be subject to such risks.

To hedge against these risks, we may add non-stock assets such as bonds to our portfolio since stock and bond returns have historically had low correlation. In fact, if you take a look at the composition of some "equity" funds, you'll see that 20 to 30% of these are actually invested in corporate bonds and Treasury securities--precisely to achieve this kind of diversification at some level. Of course, the most explicit diversified investments of this nature are so-called "balanced funds," as you have mentioned. And we may even expand our portfolio to include other assets such as real estate, private equity, and commodities.

Going up one more level, we can perhaps imagine events and circumstances that would affect only specific countries or even regions of the world. Country risk is specific to a particular country, and is a function of the country's political stability and institutional development, among other factors. In 1997, the Asian financial crisis affected most of the economies of East and Southeast Asia, while leaving the rest of the world relatively unaffected. Perhaps the most straightforward way hedge against this kind of risk is to invest in assets outside the Philippines, which is the main concern of your email.

I'm afraid that your questions will have to wait for Part 2, though, which I promise to post in a couple of days.

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