Have You Achieved True Diversification In Your Investment?

Most of us don’t know if we have the right level of diversification until something unfortunate happens, and then we go down the dreaded “If only…” path. Such was the case with Andrei, my junior analyst at the bank where I worked in Moscow in 2007.

Andrei had a degree from a Russian university and had a job in finance making good money during the pre-crisis boom times.

He had some savings in Russian rubles at a local bank, and a mortgage on a flat downtown. He felt like an investment genius because his speculations in Russia’s booming stock market were paying off, and the ruble was rising.

Then the global financial crisis hit in 2008-2009. The world economy fell ill, and commodities-reliant Russia caught pneumonia. The country’s stock market fell 80%, and the economy contracted 9%– the most of any large economy in the world.

It didn’t take long for Andrei’s life to fall apart. He lost his job, as the bank we worked for wobbled on the edge of bankruptcy. The ruble collapsed, and the value of Andrei’s savings fell by half in real terms.

Adding salt to the wound, the bank that held his cash “froze,” and Andrei couldn’t get his money out. He couldn’t make his mortgage payments and the value of his stock portfolio evaporated.

With only a Russian passport and the ability to only speak in Russian (with limited English), Andrei couldn’t easily go anywhere else. And all he knew was finance – and there were more out-of-work finance professionals than there were holes in the road.

How did it all go downhill for Andrei?

The short answer is: Andrei was not diversified. He has neglected his “personal equity”.

What is personal equity?

Personal equity is more than what you own now – it’s about how you’re going to build your equity in the future. Most people ignore what I call “personal equity” when they’re thinking about diversification.

When people think of “diversification,” they usually focus on asset allocation – their portfolio’s mix of assets like stocks, bonds, cash, real estate and other financial assets.

Some may think, “Okay, my money is spread around. I have money in the stock market, bonds, and real estate. So, I’m safe.”

But you’re probably a lot less diversified than you think. And this goes beyond your investible assets – they’re just one part of the diversification equation.

The other, perhaps even more important, part of diversification, has to do with factoring in your personal equity.

Personal equity is about how you are going to earn your current and also your future income. For example, if the economy fails in the country that you are in, do you have the skills and capabilities to rebuild a source of income elsewhere?

Are you only deriving your income from one basket, or does your income come from different sources?

As my Russian friend Andrei found, not diversifying one’s personal equity can spell financial disaster.

His professional and personal “equity” were all in the same basket: Russia. And when things went bad in Russia, Andrei’s personal equity evaporated – not only his current assets, but also his future.

Diversifying your assets

Besides personal equity, true diversification, of course, includes having the right mix of assets. But caution is needed here as well. Owning some Malaysian shares, a Singapore bond fund and an S&P 500 Index ETF does not mean you’re well-diversified.

That’s because the correlations between different financial assets are higher than most investors realise, as shown in the table below. For example, the Singapore stock market has a correlation of 0.88 with the MSCI Asia ex Japan Index and 0.68 with the S&P 500 – both very high. So, in the case of Singapore, geographical diversification doesn’t help much.

On the other hand, Malaysia’s KLCI has a relatively lower correlation with Singapore, Hong Kong and the MSCI Asia ex Japan Index – but it’s still more than most investors tend to think.

This leads to what I like to call the egg truck problem. Imagine this: You put your eggs in different baskets (just like all the investment gurus said), but all the baskets are on the same egg truck. In a big financial correction (or even a small one), the egg truck that’s carrying all your different egg baskets crashes.

True correlation involves different egg trucks carrying your egg baskets – because a high correlation between assets is dangerous.

Having some gold in your portfolio is one of the best ways to address this issue. Gold is some of the best insurance that you can buy and as the table above shows, gold has a low correlation with most major stock markets – and a negative correlation with the KLCI. This means that gold tends to move in the opposite direction of what the KLCI does.

Another way to effectively diversify your portfolio is to use ETFs, or Exchange Traded Funds. These funds trade like a stock on an exchange and track a stock or bond index, different sectors or commodity prices.

However, there may be limited choice of ETFs that trade on the KLCI. There is a Malaysian bond ETF, some Malaysian equity ETFs, a Chinese stock ETF and some Islamic Southeast Asia and Asia Pacific ETFs. (The full list can be found here.) These are a good starting point.

To further diversify your portfolio, you can consider ETFs that trade on the Singapore or Hong Kong Exchanges.Most brokers or platforms allow you to trade ETFs from these two countries. They have a wider variety of ETFs available, including ETFs that give you exposure to gold prices. The SPDR Gold Shares ETF (Singapore; code: O87) and the Value Gold ETF (Hong Kong; code: 3081) are both good options.

The best way to diversify

But your money is only part of the story. The rest of the picture is about where you’ll be earning your living – adding to your savings – in coming years. Where is your pay cheque coming from? What other sources of income do you have? That’s how you can get a sense of how diversified you really are.

Most people work in the same country where they have almost all their assets. And even if you do hold some foreign shares or own real estate in another country… when you factor in where you’ll be earning money in the future, you’re probably a lot less diversified than you think.

If you’re going to be living in the same place for a long time, maybe forever, it probably makes sense to have a lot of your personal equity in that country. If you live and work in Malaysia, what’s wrong with holding all your assets in (say) Malaysian stocks, bonds, and ringgit?

There’s not necessarily anything bad about that. After all, it’s what most people do. But it might be riskier than you think.

What if the banking sector goes bust… the ringgit massively devalues… the real estate market crashes… or the government starts searching for ways to plug a massive budget deficit, and your assets are all in that country? They’re just cherries for the picking.

My friend Andrei had one other big asset in his personal equity: Time. He went back to school, learned some English, and reinvented himself as a consultant. Now he’s living in London.

Andrei learned the hard way that he was nowhere near as diversified as he thought he was. Stocks, bonds, real estate and other financial assets are just one piece of the equation. Your “personal equity” is much bigger than that. And in the long run, it matters a lot more.

What does this mean for you? Think of diversification in a way that encompasses other countries and currencies, as well as skills and geographies. If your strategy towards investment – in financial assets as well as your personal equity – is completely diversified, you’ll be a lot better off in the long run.

This article was first published on Truewealth Publishing