Co-founder and CIO
15 March 2019
Editorial note: Our thoughts go to the families affected by the two recent plane crashes. We’re using this example solely to draw investment lessons that can illustrate how quickly and unexpectedly even a large, reputable company’s share price can drop, and how that can affect an improperly-diversified portfolio.
On 10 March, the Boeing 737 MAX aircraft flown by Ethiopian Airlines crashed near Addis Ababa, killing all 157 people on board. This comes less than 5 months since another Boeing 737 MAX aircraft plunged into the waters off of Indonesia. As investigators look to uncover root causes of these accidents, a growing number of aviation authorities around the world are grounding Boeing’s 737 MAX aircrafts. The debacle has sent Boeing’s share price down 14.8%, from $440 USD to $375.41 USD between 1 March and 12 March.
This example of a highly reputable company’s stock price plummeting with its planes goes to show the vagaries inherent with investing in single-name securities. Unexpected events can severely impact the value of a particular investment, negatively or positively. It’s not rare, and it’s unpredictable: for example, it happened last year to Facebook with Cambridge Analytica. The lesson investors can draw here is to have a diversified portfolio so they can sleep better not worrying about potential events within a company, such as plane crashes, a privacy scandal, a CEO affair, or about external impacts on a company, such as a sharp increase in oil prices.
Using what’s going on with Boeing to illustrate the importance of diversification, let’s compare the daily percentage change in the share price of Boeing against VTI, which is a Vanguard ETF that tracks the CRSP US Total Stock Market Index. The latter is a very broad representation of the universe of investable stocks in the US, and is made up of more than 3,500 companies. The benefit of diversification is very clear here: in Figure 1, we can observe that the swings in the Boeing stock price (orange line) can be as wide as +/- 7% per day. This volatility is significantly wider than that of the tracking ETF (blue line).
Source: StashAway, Bloomberg
Beyond smoothing out price swings, diversification also mitigates the problem of being exposed to event risks, such as companies being delisted or going bankrupt. It is simply too onerous and complex for an investor to track and analyse a large number of single-name securities to find winners and avoid losers.
Diversification is also not about simply having a large number of securities in a portfolio. Things become significantly more interesting when an investor starts including different types of asset classes into their portfolios. An effectively diversified portfolio would be invested across geographies, and strikes a good balance of allocations to growth assets (e.g. technology stocks, etc) and protective assets (e.g. government bonds, high-grade corporate bonds, gold, etc).
Defying all negative expectations, growth-oriented assets have reversed their doldrums in late-2018, and performed admirably in the first quarter of 2019. Small-cap growth stocks (the riskier tranche of the US stock markets) was pronounced dead at one point in late 2018. The sector went on to outperform with a YtD return of +19.2% in 2019. In the technology sector, regulatory pressure on companies remain an issue and could possibly re-escalate into the 2020 US general election when opportunistic Presidential candidates capitalise on public sentiments to regulate or break up big tech firms. The irony? US technology sector (as proxied by the US technology ETF, XLK) delivered +16.8% in YtD return anyway.
Due to a more accommodative stance from major central banks (US Federal Reserve, European Central Bank, Reserve Bank of Australia and so on), interest rate-sensitive assets such as the Real Estate Investment Trusts have rebounded well. In particular, real estate investment trusts (REITs) in the US, Asia ex-Japan region, and Singapore have all performed well with YtD returns of +16.1%, +9.4%, and +8.5%, respectively.
So far in 2019, growth-oriented assets (dark blue bars in Figure 2), outperform protective assets (light blue). Consumer staples, with its +8.5% YtD return, is the only protective asset on our radar that have performed comparably well. Other protective assets such as Singapore Government Bonds have underperformed with a YtD negative return of -2.7%. Having said that, we think it’s important for investors to always maintain a sufficient amount of protective assets in their portfolios, regardless of how they perform in the near term.
Source: StashAway, Bloomberg
Note to Figure 2: Each of the asset classes in Figure 2 are proxy by a tracking ETF on StashAway’s radar or by the underlying indices.
It’s important to keep in mind that we should not allow short-term performance, whether it’s up or down, to influence our long-term investment plan. A good investment plan helps you set the right risk levels to be compatible with your life goals and personal risk tolerance. Your plan should be prepared to roll with the natural ups and downs of the markets. A good investment plan also effectively diversifies a portfolio to strategically avoid concentration risk in any one security or asset class.