Seeking Returns

International Diversification for your financial portfolio

An investor can reduce risk exposure of your portfolio when the foreign assets have low portfolio correlation. This means that you own a portfolio of stocks that generally move independently of each other. When a market crashes, we can expect another market to crash less or even increase in value.

There are 2 components of risk in foreign assets. Firstly, there is volatility in the inherent asset. Secondly, there is risk in the foreign currency. These can be view positively as well. When one purchases an international stock, he may stand to gain from the asset capital gain and the currency gain.

Selecting global diversification is not an easy task. Generally, if you purchase assets from economies that are linked together or affected by the same factors, you have not diversified funds well. Buying stocks from the G7 exhibit high correlation and yield lesser diversification benefits.

Chart above shows that one can increase expected returns at the same risk level when one diversifies across international markets. One must be careful to note that naïve diversification across random nations do not yield adequate diversification benefits. An investor needs to determine specific asset correlation with the market and the contribution of risk to the portfolio.

Dealing with currency risk

Currency risk can be hedged away easily. If you buy US stocks, you can hedge by selling an equal amount of US dollars to hedge the dollar exposure. However, if you hold many foreign stocks, currency risk can be similarly diversified away in a portfolio comprising several currencies. This is an additional benefit of portfolio international diversification.

Long term trend of diversification

There are existing criticisms for international diversification. Some say that the global economies have integrated into one economy. If so, diversification benefits are eliminated automatically. There is no difference investing in Singapore, China or the US.

Why would critics say so? Firstly, free trade has increased. Economies depend on each other. Capital markets have globalized and corporations are no long localized. Mobility of individual capital has increased tremendously.

However, the truth is somewhere in between. Diversification strategies continue to be used by professional money managers. As an individual, we should adopt international diversification of our money to ensure lower risk for same amount of expected returns.

Alex Lew

Alex is the Vice President, Society of Financial Service Professionals (Singapore) and a Certified Fraud Examiner

Mitigating Behavioural Biases in Portfolio Management

We wrote an article about behavioural biases in investing. As financial professionals, your advisors will have to mitigate or accommodate these biases in your asset allocation. This means that they have to recognize human weaknesses and incorporate loss aversion and mental accounting factors into your portfolio.

A rational portfolio that does not fit the behavioural characteristics of the investor will not seed well. Here’s an example. If your investor is suffers from loss aversion, an advisor will find it hard explaining his decision to keep a stock that has fallen 30% since purchase. In actual fact, a financial professional looks at asset correlation more than single instrument performance over a long period of time.

Sometimes, advisors build a portfolio with clear layers to enhance client’s confidence. A clear portfolio layered with risk free instruments and risky assets can help the client understand the risk more clearly. In a purely scientific manner, an efficient portfolio should be construction base on its correlation with the market and with risk/return concept. Layering the portfolio clearly will not contribute towards an efficient portfolio, but it helps to mitigate behavioural biases.

At this point, we discuss the asset allocation which takes into consideration behavioural biases. It should be noted that the wealthier the client, the more biases the investment professional can accommodate. If the client is not wealthy, an advisor will find it very tough to incorporate biases. This is because the wealthier portfolio has a larger margin of error. Even within different types of biases, we should work to mitigate errors due to lack of information and knowledge power to process information. These can be mitigated by outsourced information providers and acquiring skilled managers. Emotional biases (lack of self control, over confidence, loss aversion) should be accommodated that these factors are culturally in-built.

Some measures to mitigate biases in asset management

When one performs an extensive analysis of the stock, the investor clarifies the risk he undertakes. He can record these reasons down and tracks his performance over time. This record should build confidence over time.

Even before one builds his portfolio, an advisor should help to create goals for the client. With these goals, the client can dutifully save up. The pool of savings can allow construction of a portfolio rationally.

Lastly, clients should undergo classes about risk and return on an ongoing basis. This is to ensure that they remember these important concepts and not be triggered to action because of price movements.

Alex Lew Yan Liang 刘彦良

Certified Fraud Examiner