Peter Bernstein, a financial historian, once argued that humanity’s ability to understand, measure and harness risk is one of the central ideas that divided modern times from our distant past, liberating us intellectually from star-gazing and soothsayers
I’m inclined to agree.
The one question I usually get
Whenever I meet people at social gatherings, and they find out about what I do, the conversation inevitably turns to one question: “How can I improve my investment portfolio?”
It turns out that, for many investors, there is indeed a simple way to invest better.
Before we go there, however, we’d need to grasp the fundamental concepts of risk, return, and the risk-free rate, and how they tie into modern portfolio theory.
The fundamental concepts: risk, return, and the risk-free rate
First, risk is the likelihood that the actual returns of an investment would differ from its expected returns. This is commonly calculated by the standard deviation of the annual returns of a specific investment.
Second, the rate of return refers to the amount of gains made from an investment as a percentage of the initial capital deployed.
Finally, the risk-free rate is the highest rate of return available in the market whereby one can have complete certainty that the actual return of an investment will not differ from its expected return (at maturity). This is usually taken to be the US Treasury yield, which is backed by the full faith and credit of the US government.
These three concepts tie into a key notion in modern portfolio theory: For an investor to generate higher expected returns than the risk-free rate, they will need to take on additional risk, and therefore bear the uncertainty that actual returns can deviate from what is expected.
Simply put, investors need to take on additional risk in exchange for higher expected returns.
Diversification can improve portfolio risk-reward
This leads us to a critical question.
How much additional risk is an investor taking on, in exchange for every percentage of additional expected return?
Clearly, the lower this risk-reward ratio is, the better off the investment portfolio is.
By now, many studies have proven that investors can effectively improve the risk-reward of their portfolios by diversifying into investments that exhibit low correlations with each another.
Does diversification really work?
One way to do this is to allocate into investments from different geographies, sectors or asset classes. Let’s look at a simple example.
Take an investor with only Singapore-listed stocks. The annualized return for stocks in the Straits Times Index (STI) over the past 10 years was 1.6%, while the risk level (defined as the standard deviation of returns) was about 18%. Compare this with another investor with a portfolio made up of 50% STI stocks and 50% Standard & Poor’s (S&P) 500 stocks. The annualized return for this investor rises to about 4% while the risk level is actually lower at 16%.
Take this one step further by looking at a portfolio comprising of one-third STI, one-third S&P 500 and a final third of emerging-markets investment grade bonds. This investor’s returns remain at about 4% per cent, but the risk level drops to just 12%.
Low-hanging fruit: eliminate the “home-bias”
We now come full-circle to the one question I get at social gatherings: “So how can I improve my investment portfolio?”
For many investors, one low-hanging fruit is simply to eliminate the “home-bias” in their portfolios.
The home bias refers to a common phenomenon whereby investors prefer to invest most, if not all, of their portfolios in their own country or region. As a result, their investment portfolios are not effectively diversified, and have poor risk-reward characteristics.
This behavioral flaw is well-documented by academics.
In one paper, “Understanding the Equity Home Bias: Evidence from Survey Data” published in The Review of Economics and Statistics, authors Strong and Xu found conclusive evidence that fund managers in the US, UK, Europe and Japan widely exhibited significant bias towards domestic equities which cannot be attributed to institutional factors.
Why does the home bias exist?
It turns out that investors often confuse familiarity with knowledge, and therefore suffer from over-confidence with local markets or investments that they are more familiar with.
Investors also often have the perception that it is more difficult to invest in foreign markets, whether it is to do with more legal restrictions or additional transaction costs.
For instance, a high net-worth individual in Asia may have – in addition to a substantial stake in a regional family business – significant real estate exposure in major Asian cities. Often, because of familiarity with the region, his investments in listed equities and fixed income also show excessive exposure to Asia.
For this individual, however, by systemically reviewing and diversifying his investment portfolio across geographies, he can eliminate the home bias and improve the long-term performance of his investment portfolio.
At Bank of Singapore, our asset allocation strategy and recommendations are built on effective diversification across asset classes and geographies. At the same time, our deep bench of investment professionals actively enhances long-term performance with strategies based on economic trends, structural themes and bottom-up research.
Does your investment portfolio have a home-bias?
Source: CEIC, Bank of Singapore
China is clearly at the top of the list for US tariffs, accounting for nearly half of the trade deficit. Next in line are Mexico, Japan and Germany, although the combined deficit with these three is around half of that with China. Friction with China seems qualitatively different, as it reflects a growing super-power rivalry, rather than a negotiation for more equal market access.
Mexico looks safe after the recently-updated NAFTA agreement. Rather than focussing on Japan or Germany specifically, it seems more likely that restraints on automobile imports address a large part of the imbalance (US auto imports are $365bn compared to exports of $161bn).
Tariffs on autos are currently under investigation and that could be disruptive for two reasons. First, Europe is likely to retaliate in kind. Second, it is hard to find substitutes, so the impact on US prices will likely be significant. US consumers paid the price of restrictions on Japanese car exports in the 1980s. In the case of tariffs on China, it is relatively easy to shift demand to, say, Vietnam or Mexico so overall US import prices do not rise too much. However, if the end result is negotiation, compromise and (eventually) more liberal trade then short-term pain could bring longer-term gain.
In theory, the Fed should not respond to a one-off change in the price level due to tariffs. However, in a hot economy it will be wary of knock-on effects pushing up underlying inflation. If price expectations rise, the Fed will be under pressure to tighten more aggressively.
Prediction markets are putting 2:1 odds on the Democrats taking control of the House of Representatives at the mid-term elections. If so, this will restrict many areas of Trump’s domestic policy-making. However, trade policy is largely under the control of the president, so we should not expect friction to abate.
Disclaimer applicable to recommendation
Weak financial markets could persuade Trump to back away from further action on tariffs. However, he seems determined to try to pin any blame for volatile markets on the Federal Reserve, which could indicate an intention to persist. The probable rise in the US trade deficit over the coming year – to record levels – will give him plenty of fuel to feed his discontent.
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