Let’s be honest. Most investors think they can predict the future. Else, how do you explain the fact that most people hold fewer than ten stocks in their portfolio? The standard reply that it’s expensive to buy a diversified portfolio doesn’t cut – there is such a thing as exchange traded funds! On the SGX for example, there is the SPDR Straits Times Index ETF and the Nikko AM Straits Times Index ETF, both of which track the 30-stock Straits Times Index very closely and with low expense ratios to boot. Indeed, why stop at Singapore, a tiny red dot in a big big world? Why miss out on the business opportunities presented by hundreds of firms spread across the continents?
The real answer to these “whys” is that investors simply don’t like diversifying broadly. What they want is bet on a few stocks in the hope that these stock pircks will turn out to be “jackpots”. Unknowingly, they fall into a behavioral trap called the overconfidence bias, an exaggerated belief in your skills to pick winners. A related bias is the “home bias”, which is the tendency to concentrate all your investments in one country like Singapore if you are a resident of Singapore, Japanese, if you are a resident of Japan, the US if you are an American resident and so on.
To my Singapore readers, let me share with you the facts based on a long record of stock market returns from 1970 to 2017, a period of 48 years. The underlying data are monthly MSCI stock index returns for 17 countries comprising Singapore and 16 other developed markets (please refer to Blog #31 for a list of these countries). I construct a world portfolio by giving each of the 16 foreign markets equal weight. All returns are in Singapore dollars.
I will summarize this large data set by showing three things: (a) the average returns of the world portfolio when the Singapore stock market experienced the worst 10% and 20% returns over the whole sample period, (b) the average returns of the world portfolio when the Singapore stock market experienced the best 10% and 20% of returns over the sample period and (c) the average return for Singapore and the world excluding Singapore’s best 10% returns (because these extreme returns are rare). I report all averages as annual numbers (i.e., 12 times the monthly average).
Here are the results.
The first panel of the table shows average returns in the worst 10% and 20% of months in the Singapore stock market (SG). This “worst average” is called the 10% and 20% conditional value-at-risk or CVAR. You see that the world portfolio suffered a smaller average loss than SG when the local market was “in the toilet”. For example, while SG suffered an average annual loss of 15% in the worst 10% of the sample, the world portfolio was down by only 4%. In other words, SG under-performed the world portfolio by 8% during these periods (last column). A similar result holds for the worst 20% of months for SG.
The middle panel shows the flip side of the above results. Here, I present the conditional value-at-gain (a term I invented). What this panel says is that when SG is doing very well, the world does well too, though not to the same extent. So, in these jolly periods, SG outperformed the world portfolio. Consider this as the price you pay for protection from diversification.
The last panel throws out the best 10% of SG returns to see what happens in less exuberant periods. The results are surprising. First, the average return for SG is now close to zero (the actual average is negative 0.19% per year which is close to zero). Hence, if you miss just 30 of the best months in Singapore, you earned almost nothing for your effort. I don’t know about you, but I sure don’t want to stake all my money in a market where the growth of my retirement money depends on just a handful of over-the-top returns.
How about the world portfolio? The same panel shows that even when we exclude the best 10% SG returns, the average return of the world portfolio is still positive and indeed, a highly respectable 8% a year. While this is about 2.4% lower than the full sample world average, it is clear that the world portfolio is only marginally affected by the (irrational?) exuberance of the Singapore stock market. This stability is the precious gift of global diversification.