SINGAPORE (July 3): Economic and stock market crashes are inevitable. But you never know when and how. It’s like death. Until it happens, you’ve got to live as well as you possibly can. It’s the same with investing.
Last week, we noted how it is impossible to predict market directions. Even if the optimists are right — that the world is in secular deflation and digital transformation will drive economic growth and corporate earnings much higher — the fact is that, even in long-term up cycles, there will still be short-term swings.
In particular, what is really worrying is the way passive funds, including exchange-traded funds (ETFs), have grown. As mentioned last week, the attractiveness of its low costs is also its Achilles heel.
Without regard for the intrinsic value of stocks, it is simply a case of money chasing stocks, pushing stock prices higher, which in turn results in even greater buying of the same stocks as funds pour into the ETFs.
The actual fact or performance of a company does not matter at all in a passive-investing world. But it will matter at some point. And when it does happen, price declines will not be gradual. The higher the rise, the further the fall.
The value of ETFs will fall even faster than the underlying equities as money gets withdrawn, forcing a further selldown of stocks and creating a rapid cascading effect.
Putting money to sleep in the bank generates negative real yield. Owning fixed-income bonds and other assets in a rising interest rate environment is counter-intuitive. The best use of money is to spend it — but then you need to provide for your old age and worry about your children. So, if you decide to invest partly in the equity markets, what can you do, given the heightened risks and uncertainties?
Don’t own the market. The market as a whole may be overvalued, but your portfolio of stocks should not. Build a portfolio of high-quality companies that are undervalued. A fine example would be Warren Buffett, who has outperformed over the long run, embracing this “simple” strategy.
Another example would be my value investing portfolio, which is a real portfolio (the account is with Maybank Malaysia) and published weekly in The Edge Malaysia. This portfolio has outperformed the broader market by a long distance since inception on Oct 14, 2014.
Total portfolio returns as at June 29 now stand at 68.8% compared with the 3.2% decline for the market benchmark, FBM KLCI. Perhaps more significantly, it has outperformed in two out of every three weeks during this period, underlining the consistency of its performance.
Your next question might then be: “How do I build my own portfolio?”
A very good starting point would be Absolutely Stocks, which is designed to help you navigate all the financial jargon and find those quality, undervalued stocks.
Instead of having to calculate each ratio and weigh their importance, likely a daunting task for many non-financial professionals, AbsolutelyStocks consolidates the key ratios into Fundamental and Valuation Scores. The higher the score is, the stronger the fundamentals and the more attractive the valuations. The site also has InsiderAsia reports for those who want to know more about the stocks they are putting their hard-earned money into.
The stocks in Tong’s portfolio are based on InsiderAsia recommendations, using data provided by AbsolutelyStocks. We have proven that value investing works. And you don’t have to be a good analyst yourself.
Alternatively, instead of choosing stocks and investing, which is admittedly more troublesome and has higher costs but could have better returns, you could also create a portfolio of funds.
Markowitz’s Modern Portfolio Theory says risk-averse investors can construct portfolios to optimise/maximise expected returns based on a given level of market risk.
The hypothesis is predicated on a diversification of uncorrelated assets, that is, an asset’s risks and rewards should not be viewed as a standalone but how it affects the overall portfolio risks and returns.
But the unfortunate reality is that buying into any one fund does nothing in most cases because most funds hold underlying assets that are highly correlated. So, instead of diversifying risk, it is diversifying losses.
The simple fact is that fund management companies apply the same investment strategy and trade in similar asset classes for all the funds under their management. Consequently, the performances of all their funds are highly correlated.
Minimising your risk by buying into different funds is both a fallacy and a myth in most instances. Since fund managers make money by selling you their own funds, they have no incentive to help you diversify.
Although less so, the same can be said of independent financial advisers and banks selling funds. They sell you only the funds they can earn a fee on. To help you diversify, they must know all the other funds you own and be able to tell you the co-variances of each of these funds. I absolutely doubt they have the incentives to do so.
In summary, it is my proposition that creating a portfolio of global stocks based on intrinsic valuations is a practical application of diversification and asset allocation strategies. It is consistent with the Modern Portfolio Theory, often articulated by financial experts, absent the terminologies that are often confusing.
My underlying reason is that value investing minimises the correlation of the assets in the portfolio. If they are highly correlated, they will all be either overvalued or undervalued. In other words, all the assets will be either a “sell” or a “buy”, and therefore there will be no need for an allocation decision.
I will elaborate more next week. Also, I feel I should write more on the dangers of passive investing.
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore.
