Like Lego play, is your investment portfolio built to last?

CHILDREN (and adults) around the world have found delight in the art of Lego construction. 

Each Lego piece is popped out from moulds made accurate to the margin of 0.005 millimetres. Each piece fits snugly, can support the weight of 375,000 bricks atop it. That precision and attention to detail create a good foundation for whatever model is being built.

So literally, the building blocks matter. And if that matters for a toy company, the same question must surely be asked about how your investments are being built to fit, and last.

How to build a diversified portfolio

Nobel prize-winning economist Harry Markowitz called diversification "the only free lunch in finance". By building an investment portfolio with assets that are not perfectly correlated, you lower portfolio risk without sacrificing expected returns.

If you have a higher risk tolerance and a longer investment horizon, a bigger share of your investment would likely be allocated into equity funds. If you have a lower risk tolerance, your portfolio would mostly skew towards global fixed income funds. 

This is how portfolio diversification, as anchored by years of scientific research, is executed.  A classic 60/40 portfolio for moderate-risk investors has historically delivered 9% p.a. From 1926 to 2020.

Read more: Is the classic 60/40 portfolio “dead”?

Many people talk about asset allocation, but then start putting additional layers, such as geography, sector, industry, or style. 

Here is exactly where this wild confetti of variety is wrongly conflated with trying to achieve portfolio diversification. There is only so much risk that can be diversified away to an optimal level — beyond that point, you are actually making active allocations that increase risk instead of reducing it. 

A well-diversified portfolio will always have a few investments that are faltering, such as a tiny percentage of exposure in Russian companies, or Chinese stocks facing policy risk. 

But by using highly diversified funds, the size of these positions are relatively small in a portfolio comprising more than 10,000 stocks and bonds. There is not one name or one position that will blow up the portfolio. 

This gives investors greater peace of mind to stick to their long-term investment plans and increases the probability of success. At Endowus, we call this a core portfolio built on Strategic and Passive Asset Allocation (SPAA).  

The home bias trap

The passive-portfolio approach is completely different from tactically allocating money to various countries and sectors. That is an active approach to investing. 

Imagine having a fund that tracks the Chinese technology sector making up nearly a quarter of your portfolio. That’s an example of an active tactical allocation to a very narrow segment of the global markets that you should not be exposed to in this outsized manner. 

If  your portfolio allocates such a meaningful position in a single market — instead of the whole global market — your returns will be more volatile. They are, in effect, running the portfolio like active traders. Such active investing normally does not bring good outcomes over time.

Read more:  Understanding home bias amongst Hong Kong investors

Investors can certainly use a core-satellite strategy with satellite positions that give additional exposure to a specific market, theme, or sector, or buy single funds to express a tactical call. But it starts with a well-diversified core portfolio designed to track the broad market over the long term. 

Brickbats and ETFs

There is a misconception that all exchange-traded funds (ETFs) are passively tracking the markets. There are now more ETFs globally than the number of stocks — so it cannot be true. 

Returning to the Lego analogy, think of ETFs as bricks in all random shapes and sizes. They are not uniformly built, or from the same precise mould; many of them are, in fact, tracking different sub-sectors of a single country’s market. Numerous ones are not even indexed and traded actively, such as the ARK ETFs.

A portfolio modelled on these ETFs in different shapes and sizes is effectively built on a narrow, uneven base. That’s very different from a portfolio built with building blocks that are passively tracking market indices on a broad, diversified basis — be it through ETFs, mutual funds (also called unit trusts). 

Read more: ETF vs mutual fund — which is better?

How portfolios are built makes all the difference, especially during times of market volatilities. 

Is your investment portfolio built well, like good Lego pieces fit snugly and precisely in place? Or it loosely put together with fake Lego pieces and false promises — if so, that just might buckle and fall apart under pressure.

Build a diversified portfolio in just a few minutes through Endowus

On Endowus, we offer pre-curated risk-adjusted portfolios, such as our Endowus Flagship Portfolios that offers a one-stop solution for investors looking for low-cost globally diversified exposure. 

You can also create your own diversified, resilient investment portfolios with 200+ Best-In-Class funds selected by our Investment Office. 

These funds are selected by applying a strict, institutional-grade screening process that is rigorous, thorough, and continuous — we call this proprietary framework SMART+. Browse our complete fund list here.

We also offer other core portfolios focusing on cash management and income needs, as well as satellite thematic portfolios covering Global Technology, Future Trends, Sustainability Equities and China Equities.

For our Professional Investors clients, you can get access to additional selection of institutional-grade PI-only mutual funds, hedge funds and private markets across private equity, private credit, absolute return multi-strategy hedge funds.

Existing Endowus clients can verify as a Professional Investor by filling out this opt-in form to access these funds. You can also contact support.hk@endowus.com if in doubt.

As your conflict-free financial advisor, Endowus remains committed to doing what is always in the best interest of our clients, and to help you achieve better investing outcomes. 

Click here to get started on your wealth journey with Endowus Hong Kong today. 

The original version of this article first appeared in The Business Times and has since been updated.

Read more:

• Is diversification dead?
• How to invest your first US$100,000 or US$1 million
• Introducing Endowus Flagship Portfolios: a core strategy for your financial goals

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