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Another reason why you should invest in mutual funds: Diversify in a cost-efficient way
November 3, 2009

The success of many great investors in the world is more than the superior returns they generate every year. Diversification enhances the resilience of the portfolio. Mutual Funds offer a cost-efficient way of diversification.


Author : iFAST Research Team



Untitled Document
Chart 1
Chart 2: the more you lose, more your investments need to earn to makeup the losses

KEYNOTES

  • Diversification enhances the resilience of the portfolio.
  • Investors shall be able to differentiate between investing and trading. Investment requires patience and commitment!
  • Some of the advantages of investing in mutual funds include fairly-well diversifications at a low cost, affordable initial investment amounts, and professional management.
  • Mutual funds can provide a better risk-adjusted return and a cost-efficient way of diversification.

Why does diversification play such an important role in all aspects of investment?

Let’s first see a dialogue as below.

  • Investor A: I’ve tripled my money this year!
  • Investor B: You’ve outperformed many fund managers.
  • Investor A: Sadly… I still haven’t got back my initial investment. I lost 70% in the financial tsunami.

  • Sounds familiar? This article explains how things turn out that way for most investors.
    Let’s begin with some simple Maths. Imagine that you have Rs.100,000 and you lose 5%. How much do you have to earn in order to recover your initial investment? 5%? Maybe true. Then if you lose 20%, how much do you have to earn to recover? Is it 20%? The answer is incorrect (Rs. 80,000 x 1.2 = Rs. 96,000 < Rs.100,000) ! It takes you 25% (Rs. 80,000 x 1.25 = Rs.100,000)! How much do you have to earn to recover if you lose 50%? You need to earn 100% - that is to double your monies! This is illustrated in chart 1.
    The implication is that if you are unconcerned about risk, it takes you more efforts to recover the initial investment when losses enlarge. Chart 2 shows losses up to 100%.
    Table 1: An illustration of loss and recovery relationship
    Initial = Rs. 100,000 Loss % required to recover the initial investment
    Rs. 95,000 5% 5%
    Rs. 90,000 10% 11%
    Rs. 80,000 20% 25%
    Rs. 50,000 50% 100%
    Rs. 20,000 80% 400%
    Rs.10,000 90% 900%
    Source: iFAST Compilations

    In fact, the success of many great investors in the world is more than the superior returns they generate every year. To start with, you should read Warrant Buffet’s famous quotes regarding to his value-investing philosophy. The followings are some of them: Rule 1: Never lose money Rule 2: Never forget rule No. 1 Source: The Story of Warren Buffett, 2006 Literary Edition True! In reality, even Buffet himself cannot prevent any one of his investments from losses, but it is very important to appreciate the key message here - one should ensure the chance of a loss is minimal. Over the past year, we have witnessed the worst ever financial crisis since World War II. Some gigantic corporations fell down, including Lehman Brothers, Bear Stearns and General Motors which were once the industry leaders. Some survivors like Citigroup, the former world’s largest banking corporation, is merely trading at one-tenth of its peak. HSBC which once was considered as one of the best valued stocks with a stable stream of dividend yield also fell over 78% from its peak in 2007 before the recent rebound. The worst of the time has passed and a global economic recovery is underway, but the industry landscape has changed. What can you do if you unfortunately were the shareholders of one of them? Mutual fund, on the other hand, is able to spread the risk by holding hundreds of securities on average, depending on investment objectives. In a diversified portfolio, a fall in price of a single asset is offset by other assets, making the portfolio less volatile and more resilient.

    The Essence of Managing Risks Effectively

    In the previous article, we highlighted the essence of risk-adjusted return which gauges whether each unit of risk you take is sufficiently rewarded by the investment. Furthermore, as discussed above, the resilience of your portfolio is very essential in long-term investing. Diversification can help you achieve this goal.

    Differentiate between investing and trading

    Some people dislike diversification and argue that putting all the money into a “good” investment can maximise the return while others assert that diversification simply reduces the total return. Yet, don’t forget – investment involves uncertainties unless you invest in risk-free assets! Nobody can ever predict price movements. A single stock is indeed far more volatile than people have ever thought of, especially during market sell-offs. The common mistakes of investors are being ignorant and overconfident, which can be detrimental and place you under a very risky position. Investment requires a whole lot of patience and commitment! Whilst many people proclaim themselves as “investors”, few of them truly understand and practise the philosophy of investing. Admittedly, if you look for the excitement brought by the daily price volatility, mutual funds is unlikely your cup of tea. Investing, on the other hand, has its own game rules: “slow and steady wins the race” - remember Aesop's popular fable about “the Tortoise and the Hare”.

    Mutual Funds offer a cost-efficient way of diversification

    Cheap way to diversify

    We have illustrated the importance of diversification. But in the real world of investing, how much do you need to put in to construct a fairly-diversified, if not a well-diversified portfolio? Academic research shows that 25 – 30 securities should be included in a portfolio in order to fairly eliminate firm-specific risk (unsystematic risk) – a huge sum of money! Moreover, portfolio diversification is more than geographic or sector diversification in stock choices. Different asset classes (at least some bonds and commodities are welcome too!) should be included in the portfolio, making diversification a more challenging task. On the other hand, we can have better risk diversification when we invest in mutual fund which portfolio manager collects bits and pieces from individual investors into a pool of money and makes the investment. The transaction costs and other expenses can be cheaper through economies of scale. In addition, some internal codes command them to obey certain rules on diversification. For instance, SEBI has ruled that no single security is allowed to take over 10% of the portfolio size. Therefore, if you are constrained by your investment monies, buying two or three mutual funds (including a balanced fund plus some global equity or bond funds) with different investment objectives can sufficiently achieve a fair diversification.

    Affordable start-up

    The initial investment amount required by mutual funds is far less than some of the blue-chips and large caps. As said, mutual funds invest in a basket of securities. Thus you are virtually holding many securities but at much lesser cost of individually owning them.

    Professional management

    Fund managers are supported by team of analysts who help devise investment strategies and select securities. For investors who are interested in overseas exposures but with limited knowledge of overseas market, buying funds which are managed by local specialists can help you tap into the local expertise.

    Conclusion

    The key messages that we want to deliver in these two series are very simple. First, additional risk should be compensated with extra returns. Investors should not take too much risk for just a small increment of potential return. Second, diversification enhances the resilience of your portfolio and places you in a better position to win over the long term and lose lower in the short term. Last but not the least, mutual funds can provide you with a better risk-adjusted return and a cost-efficient way of diversification.

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    iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.


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