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Diversification: Hedging against uncertain times

A looming trade war and other geopolitical happenings are causing uncertainty in global and local markets

A way to ensure good returns with lower risk is to diversify one’s investment portfolio

For the world economy, trouble is brewing on the horizon. A trade war may be imminent – the potential fallout of other geopolitical happenings that are undoubtedly worrisome. Closer to home, certain changes are equally worrying to local investors. We may have changed governments, but that doesn’t signify an immediate change for the better.

We ought to worry. Worrying is fine. Worrying means we can prepare and be mindful of any impending crisis. Worrying too much, though, and we fail to act rationally. The idea, of course, is to be prepared.

For investors, being prepared isn’t just about hedging your bets on the brightest possible investment. Being prepared here is to manage your risks accordingly, to avoid losing all the eggs even as the baskets they’re in burn and fizzle. This means putting the eggs in multiple baskets, of different types and materials and design. In investment terms, it means diversifying your portfolio.

How do we do this and why? Ricky Chau, vice-president and portfolio manager of Franklin Templeton Multi-Asset Solutions (FTMAS), addresses what sort of trouble is brewing on the horizon and why asset diversification is important in light of this.

The potential trade war

“I think, in general, the overall global economy – in terms of global growth – is still intact and solid,” he tells FocusM. Looking at the macro economy data of this year and previous years, Chau says the data is “better and more solid than ever before”.

The big picture looks good, but it’s the growing moss at the corner of the frame that’s getting people concerned. Right now, Chau says, this uncertainty is the observable trade tension between the United States and China.

It would seem that the opening shots of a trade war have been fired, beginning with the Trump administration imposing sweeping tariffs on US$34 bil worth of Chinese goods, which meant that the goods marked for tariffs now face a hefty 25% border tax when they’re imported into the US.

China retaliated with 25% tariffs on US$34 bil worth of US goods. From there on, both economic powerhouses continued with a series of tariff roundhouses and uppercuts. It will likely continue well into the foreseeable future.

“There’s a lot of trade tension happening, which actually creates a lot more volatility than expected,” says Chau. “For the current year, we were already expecting being in a maturing bull market situation, with expected higher volatility. But with the trade tension, the volatility will be a bit higher than our initial expectations.”

There are no winners in a trade war, Chau points out. If it continues, there will be more disruptions to international trade, slowing down the overall growth right down to the corporate level, as companies may have to figure out how to move their trade away from China or the US.

“At this juncture, the key thing is to really figure out how you can better diversify or reduce the overall volatility of your investment,” he says.

Concerns there and here

The US-China trade tension isn’t the only thing worrying investors. With the impending Brexit, Chau notes that trade with the UK will be shaky as the nation begins redefining new terms of trade in Asia and even Malaysia. But it’s not all bad – there is a positive and negative side to this.

“On one hand, there is uncertainty coming, and there might be some disturbance. On the flip side, whatever terms that were not really favourable between UK and Malaysia in terms of international trade, will be reset and then revisited,” he says.

Even within Malaysia, other trade concerns are brewing. When the Pakatan Harapan government was installed, Malaysia suspended up to US$20 bil worth of China-backed projects, raising concerns over the relationship between the two countries. Chau, however, says that the revisiting of the projects is fair.

“Revisiting the big projects between China and Malaysia is actually good due diligence, I would say. I do not see it as a disruption of the relationship between the two countries. It’s more of revising how the money should be spent, in a wiser and more prudent manner,” he says, adding that the bilateral trade, investment and tourists from China will still be here.

All in all, Chau feels Malaysia’s change in government will be more positive in the long run. “With any changes to government, there will always be higher volatility,” he says, before noting that, within the Pakatan Harapan’s manifesto, policies that benefit the citizens will reflect on the economy in a positive manner.

“From where I am seeing, on a positive note, there will be less dominance and monopoly from huge corporations, which is beneficial to the overall investment environment. You may be seeing other quality companies that will be able to contribute to the Malaysian economy well,” he says.

Diversification is vital

Overall, things are frankly looking fairly good. If there’s one major worry, Chau says it would be how the aforementioned trade tension will evolve. “If the respective governments do not manage it properly, it will be a real threat,” posits Chau.

Investors will need to prepare for it, should it get worse. For this, Chau believes that diversification of portfolio is an important, vital step.

Diversification of portfolio is commonly known as the practice of spreading one’s investments across multiple asset types. It’s a way to mitigate investment risks.

“Multi-asset investments will provide you better risk-adjusted returns – it is likely that you will be getting the same or better returns at a lower risk,” says Chau.

An aspect to multi-asset investments or diversifying one’s portfolio, Chau explains, is that it can help avoid what he calls “permanent wealth disruption.” Let’s say that you, for instance, are aiming to achieve a 5% return of investment (ROI). Investors may tell you that a single stock or bond could provide that, or that investing in a specific theme or country can help you achieve it. Why bother making things so complicated?

Why you should definitely pick the complicated route is to avoid permanent wealth disruption. “A single stock can bankrupt. Bonds can be defaulted. If you’re too focused on a theme or a country, you will have a long bear market for many years,” says Chau.

He points out that diversification wouldn’t help one avoid disruption entirely. It’s so that when the disruption happens, the investor would be able to recover. If the investor practises focus investing – that is, concentrating his investment on relatively few positions – it may be too late to recover once a crisis hits.

Chau adds that even perceivably safe single-stock investments have their risks. Investors may choose to focus on a large, long-running organisation such as government-run utility companies, but it doesn’t mean that these companies won’t go bankrupt. Chau notes that the stocks of a Hong Kong telecommunications company that was acquired by another entity have failed to recover.

Multi-asset investments could help mitigate that. “It is more of a risk investment for investors,” Chau says.

How to diversify

For Chau, investors today have more access than ever to diversify their portfolio. Through newer technology and scalability, more products are now provided at the retail investor level, meaning investors need to approach professionals to access a bevy of investment types and assets.

“We now basically get the benefits that, in the old days, were limited to the rich and the sovereign wealthy,” he says.

So what would make for a good, diversified portfolio? Chau says that, first of all, the investor would need to identify his or her risk profile, which determines their risk appetite.

Following that, and this is perhaps most important, is that the portfolio must be well diversified across major asset classes, across countries and across sectors.

There’s one other vital aspect to think about – the investment manager. Chau says the investment manager’s style is important to consider, as there is a tendency for a certain managing style to dominate the market or portfolio.

In this sense, diversifying investment managers is also important. “Having a multi-manager approach to your overall portfolio can be helpful,” Chau says.

This means getting over the prevalent thinking that only a certain asset manager will become the top performer. “I often say that there is no natural-born winner, in any asset class or manager,” says Chau.

“So, from that front, I would say diversification should not just be focused on asset, country and sector, but manager as well.”

Keeping tabs

The challenge with having a diversified portfolio is in keeping track of all your investment assets. “To be honest, it’s pretty hard for the average investor. There is no easy way for anything that earns you a return. It’s all a matter of time and effort,” admits Chau.

When talking about diversified investments or multi-asset investments, Chau says it’s really about the tools, resources and time. That is, whether or not the investor has the tools, people and the time to manage all of the diversified investments.

Chau adds that what’s critical for investors is that they are mostly lacking in tools that help them in terms of portfolio construction and identifying where the risk is coming from.

Chau likens this to a World Cup football team. There are teams that are made up of professional players and managed by the best managers with the best infrastructure in place. On the other hand, there are teams with mostly part-time players who have no resources to learn and get better.

Chau’s advice is that, for investors who want to go about investing themselves, they need to acquire the tools and resources to help them. “They should not do it alone. A single person with eight hours daily will not achieve much. As a portfolio manager, I don’t do it alone – I have a quantitative team, a qualitative team and a fund selection team. I rely on these resources to make a decision,” he says.

It’s not to say that an investor can’t strike out on his own and brave the diversified investments world without going to an asset manager – they just need to be able to pull in as much of these tools and resources as they could. That means taking in information from the media, banks, and financial advisers, or anything they could get their hands on.

It’s not going to be easy, but managing money is never easy. That’s why financial institutions and services exist. It’s really just how much time, and money, you’re willing to spend to ensure that you keep your investments safe and secure. FocusM

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