Financial Education – Portfolio Diversification

Summary

This video explains the concept of diversification in investing, highlighting its importance in reducing risk. It discusses the dangers of putting all funds into one asset and introduces the idea of diversifying across multiple asset classes or assets within those classes. The script explores the role of correlation in diversification, explaining how negatively correlated assets can provide better risk mitigation. It also clarifies that more stocks do not necessarily mean better diversification beyond a certain point. Finally, it recommends using passive index funds, like the STI ETF in Singapore, to achieve diversification at a low cost.

Takeaways

• 😀 Diversification in investing helps reduce risk by spreading investments across multiple assets.
• 😀 The phrase 'Don't put all your eggs in one basket' is a reminder not to invest everything in one asset.
• 😀 A diversified portfolio ensures that if one asset fails, others may still hold value.
• 😀 Diversification can be achieved by investing in multiple asset classes or multiple assets within each class.
• 😀 The correlation between assets is crucial in reducing risk—assets that move in opposite directions provide better diversification.
• 😀 Positive correlation means assets move together, while negative correlation means they move in opposite directions.
• 😀 A diversified portfolio works best when assets are negatively correlated, which balances out losses and gains.
• 😀 Bonds have shown negative correlation with stocks at times, but finding consistently negatively correlated assets is difficult.
• 😀 Adding more than 30 stocks to an equity portfolio typically doesn't add more diversification benefits.
• 😀 Diversification isn't about adding as many assets as possible, but about reducing the correlation between them.
• 😀 A low-cost way to diversify is by investing in passive index funds like the STI ETF, which tracks the performance of the Singapore economy.

Q & A

What is the primary lesson behind the phrase 'Don't put all your eggs in one basket'?

The primary lesson is to avoid concentrating all your investments in a single asset. Doing so increases the risk of losing everything if that asset loses its value.

How does diversification help reduce investment risk?

Diversification helps by spreading investments across multiple assets or asset classes. This way, if one asset fails, the others may still provide value, reducing overall risk.

What are the two main ways to diversify investments?

The two main ways to diversify are by investing in multiple asset classes and by investing in multiple assets within each asset class.

What does the term 'correlation' mean in the context of investing?

In investing, correlation refers to how the returns of different assets or asset classes move in relation to each other—either moving in the same direction (positive correlation) or opposite directions (negative correlation).

Can you provide an example of positive correlation between assets?

A positive correlation example is between rainy days and umbrella sales. As rain increases, umbrella sales also increase, moving together in the same direction.

What happens when two assets are negatively correlated?

When two assets are negatively correlated, their returns move in opposite directions. A loss in one asset can be offset by a gain in the other, offering a diversification benefit.

Why is it beneficial to diversify investments with negatively correlated assets?

Diversifying with negatively correlated assets helps balance risk, as the loss of one asset can be compensated by the gain of another, reducing the overall impact on the portfolio.

Is it easy to find investments that are always negatively correlated?

No, it is difficult to find investments that are always negatively correlated. Even bonds, which generally show negative correlation with stocks, can have positive correlation during certain periods.

How many stocks should typically be included in an equity portfolio to achieve diversification?

Including more than 30 stocks in an equity portfolio generally does not provide significant additional diversification benefits. After about 30 stocks, the benefits of diversification plateau.

What is the role of passive index funds in diversification?

Passive index funds, such as those that track the performance of major market indices like the STI in Singapore, provide a cost-effective way for investors to achieve diversification without having to buy multiple individual assets.