The lesson of Hyflux: What water and diversification have in common

34,000 individual investors have lost a lot of money in Hyflux Perpetual bonds ("Perps"). When they were first introduced in 2011, they looked fantastic. It offered a high yield of 6% from a household name we thought we could trust. The company had signed huge long-term utility contracts with governments around the world. The founder, Olivia Lum, was a homegrown Singaporean rags-to-riches story, and as the EY World Entrepreneur of the Year, she was a well-respected leader in the business community. Most importantly, she made a product we all needed and knew well - water.

The investment was attractive enough for most individual investors, but private banks sweetened it for their clients by offering cheap leverage to juice up investor yields, letting you buy $2 of Hyflux Perps for every $1 you had. What could be better than double-digit returns every year from Olivia Lum selling water to you? The result of leverage and the lack of any financial covenants for the Perps means that these investors have been effectively wiped out.

Tariff rates on which Hyflux based their Tuaspring facility changed dramatically due to adverse market conditions, leading to spiralling losses and the company eventually filing for bankruptcy protection. As things currently stand, investors in Hyflux Perps will recoup a tiny fraction of their original investment in a restructuring scenario but will be wiped out if the company is liquidated. This is because perpetual bonds and preference shares are subordinate to senior debt and other bonds.

It is an astonishingly humbling and sad end to what was for a while an incredible success story. Following hard on the heels of the downfall of commodities trading company, Noble group, this leaves us with yet another lasting and painful impact to individual investors in Singapore. There is no silver lining for the investors who await the final outcome of the restructuring of the company, but there are very important lessons that all of us must learn from this unfortunate saga, particularly about what to do and not do when we are investing:

1. Investors like to invest in things we (think) we know.
It seems so much less risky.

Ms Lum and Hyflux were household names - a sure bet. We tend to place an oversized weighing on the importance of familiarity in our investment decision-making process. This is called familiarity bias. However, familiarity alone does not turn something into a good investment.

2. Overestimation of our own ability.

Somehow everyone thinks they know how to pick stocks and bonds when very few of us have the necessary tools or training to make the right choices and to make them consistently over time. In this case, it was too easy to overlook some of the important characteristics of perpetual bonds which made it more risky for individual investors. For example: You do not ever get your principal investment back as the bonds never mature. There are no covenants to protect you so even if the company does not pay interest, it is not considered default. The bonds are considered subordinate debt, so if anything goes wrong, you are last in line for recouping anything. To add leverage as some did was to pour fuel to the fire.

3. Putting your eggs in one basket is called concentration risk.

The painful and unfortunate outcome for Hyflux and its investors is also a cautionary tale of the importance of diversification. Investing your life savings in Hyflux Perps lost you everything. Any other diversified investment in public markets during that time would have fared much better. More importantly, let us consider the worst case outcome. For example, an investor in a diversified Endowus bond portfolio, at the peak of the Global Financial Crisis, would have lost at most 12% in 2008, which now sounds much more palatable compared to the outcome of the Hyflux bonds. What is more, the average 12-month rolling return over the past 16 years for the Endowus bond portfolio has been 5.72%. That's almost as good as the original Hyflux bond with much less risk of losing your money

4. Investing is not about profit maximizing or chasing yield.

Investing over the long-term is really about how we manage risk through the investment life cycle. Return and risk are two sides of the same coin and have a positive correlation. Higher risk, higher return. Lower risk, lower return. In the case of Hyflux Perps, the risk was much higher than the returns warranted. Especially when you supercharge it by using leverage. At Endowus, we believe investing in globally diversified portfolios of thousands of securities and across asset classes will insulate you from one bad egg ruining your whole portfolio basket, thereby protecting you from permanent capital loss while giving you the only free lunch in town - diversification.

Diversify, diversify, diversify. It is as essential to our well-being as water.