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What’s the simplest way that I can reduce risk and enhance portfolio returns?

In my previous post, I ended off by listing my 4 main investment principles. I wanted to do a quick dive into them in the next few posts.

Global Diversification

Please notice there are 2 words here – “Global” and “Diversification.” This is quite intentional.

Most people are not nomadic. They choose a corner on this earth to settle down and live in. They work, they save, and they spend in the local economy. One’s center of life usually dictates where one will be most exposed to on both a currency and investment basis. I would categorize this a “local bias.” An expatriate can culturally remain biased to their former home and stick to his/her “roots”, but economically, they must adapt to their new location. One of the major challenges we face as expats is this challenge of adapting. It could come in the form of one’s spending habits or being used to a different set of living standards, or finding out that things are just very different culturally in the new locale.

As expats, many of us have experienced the challenge that the majority of our assets remain in one country and pegged to a foreign currency, while we now have meaningful financial exposure to our new country with income and expenditures in a different currency. This “local bias” or “home bias” has major implications when it comes to financial planning and constructing an investment portfolio.

Many of us who work in Israel already have exposure to local markets through our retirement accounts. This is good on the one hand, because a good portion of our assets are then exposed to the local currency and economy. We need to continue to find ways to gain more ILS exposure through our investments and that will compliment our retirement accounts.  Another good thing that companies managing pension funds have done over the last number of years is grown their “global book” – their investments in global assets.  This is a good idea in order to achieve higher returns and lower portfolio risk, as I will explain.

Being in a small market, means more concentration

The local Israeli market is relatively small and concentrated. As an example, Bank Hapoalim, Leumi, Discount, and Mizrahi make up nearly 26% of the Tel Aviv 35 Index. All it takes is some significant volatility in the banking sector to put the entire index under pressure.

This “concentration” extends to the Israeli bond market. Many of the “liquid” corporate bonds that are considered investment grade are inherently risky and deemed below investment grade by global standards. On top of that, the local market has sectoral concentrations in real estate and in energy. Many of these bonds themselves are not very liquid to begin with, which poses additional risks. The bottom line is that it is hard to achieve proper diversification through investing in local corporate bonds when there is an issue of liquidity and not a broad enough amount of bonds to choose from.

Why do I care about diversification?

Let’s talk a little more about why having global exposure is important. The chart below shows 10-year performance of Israeli stocks vs. some major global indices. You will notice how the Israeli market has lagged behind global markets. We want to achieve the best returns and take the least amount of risk to get there.

 

To sum up, it has been proven that diversification not only reduces risk but can also enhance portfolio returns over time. The chart below demonstrates this. It shows equity returns for 21 developed market countries between 1992 to 2016. We can see that equity returns vary from year to year, and no country consistently outperforms another over time (i.e. there is no true best performer). We can even see that the US was not the best performing market in any of these years (except for 2014) and was in the bottom half in eight out of this twenty year period. Therefore, having global diversified exposures is important in both reducing portfolio volatility and increasing returns.

 

Source: Topforeignstocks.com

Diversification as a general principle

Diversification comes in many forms in life – the most obvious being in our investments, but it also can be expressed through our career choices, choices we make during our daily routine, our social life, politics, and much more.

In my next post, I will discuss strategies to achieving global diversification and explain how to maximize this concept within portfolio construction.

Green Peak Advisors are available to help you with this and all your financial planning – contact us today!