Diversification

Written By: Milja Mieskolainen

According to a survey conducted in 2015, 46% of Finnish investment portfolios contain only one share and 16% two (source: Shareownership in Finland 2015). While owning just one or two companies may make it possible to know one’s portfolio thoroughly, the benefits of diversification are overwhelming. The ultimate idea of diversification is to gather the best of for example companies, asset classes and geographical areas, into your own investment portfolio and at the same time reduce its riskiness. In an efficient market, no one can know the best investment or predict the future.

Every investment has its good and bad times, which cannot be avoided due to different types of risks. However, diversification can reduce the impact of bad times by the good and bad times of different investment targets coinciding at different times and at different stages of the business cycle. This phenomenon is due to the different ways in which investment targets react, so it may not be necessary to find just the perfect target. Investment risks are divided into market risk and company-specific risk. Market risk refers to a factor affecting the entire target market, such as a financial crisis or sanctions, that cannot be diversified away. Company-specific risk refers to the risk factor for an individual investment that can be effectively diversified away.

Diversifying your own investment portfolio does not necessarily mean compromising. The general perception is that the best return can only be obtained by concentrating investments on the most attractive investment of all. The biggest problem with this idea is precisely that the best investment cannot be seen from a crystal ball. The investment with the highest return is usually also the most risky of all. The value of a poorly diversified portfolio fluctuates easily, which can make an inexperienced investor in particular act short-sighted. A well-diversified investment portfolio also provides an opportunity to take advantage of, for example, declining markets, and start buying when prices are cheaper.

It is important to remember that diversification is not a way to generate additional revenue. Its main function is to hedge against company-specific risks, thus reducing the loss of returns caused by the downturn. It is conceivable that the most important task of any investor is to allocate their assets so that the risk-return ratio of the investment portfolio is as close as possible to the efficient front. Its main idea is that the risk and return of an investment portfolio are optimal in relation to each other. Since this optimization is based on the correlation between investment targets, it is important to always look at the portfolio as a whole. In practice, this means that in addition to the high return expectation, the correlation of the investment object with other objects in the portfolio must be taken into account.

The theory of an effective front described above has also received criticism. It can be troublesome for the investor to calculate all the necessary figures, even though they are increasingly available pre-calculated. History is not a guarantee of future returns or behavior, so actual figures may not tell us anything about the future. In addition, the theory does not measure real-world risks, such as insolvency risk, and is very sensitive to changes in the expected return on any asset. These pain points should be kept in mind when planning your own strategy.

Diversification in practice

The general opinion is that the most important form of diversification is to choose investment targets between different asset classes. Asset classes include, for example, shares, interest, currencies, forest and housing. The correlation between these is usually low, and diversification may make it possible to achieve returns when the rest of the economy is weak. Diversification between asset classes is called allocation. For example, government bonds with good credit ratings can perform well when the rest of the economy is doing poorly. Gold is also generally considered a “safe haven” for investors.

Returns by asset class 2009-2018, on the left is the highest (Source: Evli, Bloomberg.Ltd)

For equity investments, it is a good idea to keep in mind diversification within asset classes. This can reduce the risk associated with an individual country, company or sector. If you only invest in a single stock, the investment is really sensitive to political decisions or natural disasters, for example. One of the easiest ways to diversify your investment within an asset class is to buy an ETF, which often invests in hundreds of stocks or funds.

When you start investing, you need to remember to remain patient. Time diversification is easily forgotten when one gets excited about how the market works. In the long run, the investor's return expectation is positive regardless of the start date. In the short term, a situation may have arisen where you have bought at the top of the market, and in the worst case, it may take years to recover from the decline. For example, investing a student loan should be spread over several years, allowing you to study the most important aspects of investing yourself and see how the market works. By investing in flat monthly amounts or on a quarterly basis, you will have bought in both ups and downs, resulting in more in the bear market and less in the rise market.

If an investor puts 30% of their assets in the stock market that doubles over the next few years, in the end, up to 60% of the investor’s assets are in shares. Diversification has changed over the years without being noticed. It is important to remember to rebalance the portfolio at regular intervals to avoid over-allocation in a particular industry, asset class or geographic area.

Diversification doesn’t have to be complicated - it’s worth focusing on the big picture. For example, a 1% change in weight from one asset class to another does not make a significant change. At any stage of investing, the investor can think about their own strategy according to their own preferences. If you have the time and desire to explore several different possibilities, you can do so or choose one, easy, strategy and stick to it for decades. An example of a simple strategy is to follow world market weights (Ari Kaaro, Seligson & co); 30-50% in North American index funds, 25-30% in European index funds, 10-20% in Asia and 5-15% in emerging markets of the portfolio's assets, and 0-10% in Finland. Diversification into different asset classes is not taken into account here.

A slightly more advanced strategy is to divide the portfolio into tactical and strategic components. The tactical component refers to the part of the portfolio that allows the investor to be active in the market with the aim of winning market returns. The strategic approach seeks to establish the most balanced risk-return ratio possible. The strategic component usually consists of equities, bonds or mutual funds and comprises 50-80% of the value of the portfolio, and the items selected for it are not changed frequently. The tactical part is used to look for undervalued stocks that may also involve high risk and that are more actively traded.

More information:

Podcast:

Money for the rest of us: Are You Over Diversified? (available on Apple Podacsts and Spotify)

Video:

How Diversification Works?

Book:

Graham Kenny; Diversification Strategy: How to Grow a Business by Diversifying Successfully

Other investing-related books:

Benjamin Graham; Intelligent Investor

Peter Lynch; One up on Wall Street

William N. Thorndike; The Outsiders

Charles D. Ellis; Winning the Loser’s Game

Peter Thiel; Zero to One

Joel Greenblatt; The Little Book That Still Beats the Market

David Clark; Tao of Charlie Munger

Robert G. Hagstrom; The Warren Buffett Way

+Berkshire Hathaway’s Shareholder Letters read for free

Index investing and ETF’s

Written By: Milja Mieskolainen

Index investing is a passive investing strategy. The index itself describes the price development of a specific set of commodities or securities. The most well-known index is the stock index, which describes the development of a specific market. Examples include OMXH25 from Helsinki, Standard & Poor's 500 from the US, Nikkei 225 from Japan, DAX from Germany and FTSE100 from the UK.

The development of S&P 500 -index during the past five years

The best-known way to build an index, for example, is to weight shares based on their market value. In this case, a share with a larger market cap has a higher weight in the index. This can become problematic if bubbles start forming in the market or if the market is highly concentrated. This was the case in the Helsinki Stock Exchange during the IT bubble, when Nokia's share in the index was already over 50%.

In principle, an index can be formed in any way. At its simplest, 100 companies are taken and each weighted at 1%. Listed below are other, "smarter" ways to form an index.

Here is a list of other, more educated ways of forming an index:

-          Small-cap index / mid-cap index / large cap index

-          Value stock index (companies are chose based on low P/E and P/B ratios)

-          Growth stock index (high P/B ratio, expected growth in revenue and income)

-          Quality stock index (profitability is high year-to-year and leverage is low)

-          Dividend stock index (high dividend yield and/or rapid dividend yield growth)

-          Momentum stock index (stocks that have generated higher short-term returns)

-          Minimum volatility and risk adjusted index (emphasis on low-risk stocks)

Source: Sijoittaja.fi

The index itself is only a figure and you cannot invest in it per say. However, this problem is solved with index funds and ETFs. Index funds can be purchased directly from various asset management companies and ETF’s are traded on the stock exchange. Other differences between the two include management fee differences (generally slightly lower in ETF’s), subscription and redemption fees (not charged in ETF’s but stockbroker fees paid upon purchase) and dividend reinvestment (ETF’s rarely do so).

In addition to the index, ETF’s may invest in commodities such as gold or oil. They can also be used to invest in foreign stock exchange products, such as the S&P 500 index mentioned above or, for example, the Asian market. Therefore, you should also carefully familiarize yourself with ETF’s before purchase, as they may contain complex products that are difficult to value. It is also worth noting that ETF’s are generally inactive, but some are actively managed, which can increase costs. Overall, ETF’s tend to offer good diversification benefits and usually achieve average market returns. They are not necessarily 'boring' either, as you can also find special ETF’s on the stock market, such as those investing in emerging markets.

There are several classes of ETFs, each with its own pros and cons.

-          Most ETF’s are stock ETF’s. They invest their assets either in an index or in some "smart" way, such as in high dividend stocks. ETF’s that invest in the index get market-based returns, and investors who invest in other ways can achieve abnormal returns, both positive and negative.

-          Interest rate ETF’s can be divided into those investing in government bonds and those investing in corporate bonds. These include both high- and low-risk bonds. These allow the investor to, for example, invest in emerging market government bonds or reduce the risk of their portfolio by choosing the right products.

-          REIT (Real Estate Investment Trust) ETF’s invest their assets in listed REIT’s, which are required to distribute 90% of their assets in dividends. By investing in such an ETF, assets will be diversified into several REIT’s and thus, into thousands of different properties.

-          A fund that complies with certain regulations, invests extensively in commodities and is listed on a stock exchange is an ETF. If the fund invests in only one commodity, it is an ETC (exchange traded commodity). Commodity investments can provide diversification benefits when coupled with stocks.

It is also worth paying attention to the value of assets managed by ETF’s, as smaller tranches may be exposed to liquidity risk, meaning you may not be able to sell them immediately. They can be quite complex in structure and function; physical and synthetic, levered and inverted. You must be prepared to get to know them but investing through ETFs is fairly inexpensive and you have access to a large supply.

-          Physical ETF funds directly own each security according to the index. For example, if the ETF focuses on the 25 largest companies on the Helsinki Stock Exchange (OMXH25), it holds shares in these companies in the same proportion as they are in the index.

-          Synthetic ETF’s are made up entirely of derivative contracts. The asset manager may buy a basket of securities and sign a SWAP contract with the counterparty, who in gives the benchmark index return in exchange for the share basket returns. Thus, the owner of an ETF does not directly own the index-linked securities but is entitled to a return thereon.

-          Leveraged ETF’s are a relatively new phenomenon. They use at least double leverage to boost the index's return. Its value is recalculated daily based on the closing price of the previous day.

-          The reverse ETF reacts oppositely to the index being followed. As the index falls, the value of the reverse ETF rises. Such ETF’s are generally not suitable for long-term investment, but can be used, for example, to prepare for stock price fluctuations.

An index fund differs from an ETF in that it cannot be converted into cash at any time during the opening hours of the stock exchange. They can only be bought and sold once a day at the closing price. The range of index funds is also narrower, as they are usually broken down by geographical area. However, it is possible to find completely cost-free index funds that are easy and hassle-free to invest in. Their operating logic is also easy to understand, they’re relatively effortless and they’re easy to start investing in.

Both these passive investment strategies offer a more affordable way to invest, in comparison to actively managed funds. They can also provide an average market return depending on the index being followed. The market average is not bad, as most actively managed funds will lose to the index in the long run. Index funds can be a good choice as a long-term investment, while ETFs are easier to trade in the short-term. Both methods require familiarization, but with effort you can achieve good decentralization benefits.

More information on the topic:

Financial Times article: Popularity of passive investing changes the rules of the game

Book: The Clash of Cultures, John C. Bugle

Video: What is an index? - MoneyWeek (15min)

Impact Investing & Active Stock Picking – What, Where, When and How?

Written By: Milja Mieskolainen

These terms cover large entities. Let’s begin with impact investing, as it can be the basis or only a small part of an overall investment strategy. Many have certainly heard about responsible investment and taking a broader standpoint of investing, but rarely do we really focus on the differences between these purposes. Deeds mean more than words, and it’s the concrete behind the promises that matters the most.

It’s not uncommon for responsible investment to be confused with impact investing. These terms often get mixed up at least in our everyday language, which is of course not dangerous. However, if you want to think about your own strategy, it might be a good idea to get to know these themes a bit more closely. Impact investing can be roughly described as an impact that seeks environmental or social benefits in addition to returns. The more traditional and more familiar responsible investment is limited to not selecting companies that are a part of the problem.

We can use environmental protection as an example. If a person wants to focus only on the fact that the company does not harm the environment through actions such as using large amounts of fossil fuels, he is a responsible investor. When diving deeper into solving the problem by for example investing in a company that develops alternatives to fossil fuels, can we talk about an impact investor.

Impact investing is not only limited to environmental issues but can also seek to cure other long and short term disadvantages. Impact investing can be seen as a strategy used to influence the problematic chain in the long run, with each piece affecting a functional whole. Social problems exacerbate the pain points of the social network, and together they undermine the protection of the environment, which stems from the norms and schemes of things set by the institutions. If one of these components is lame, it is difficult to get a function whole that has the ability to make a difference.

As with any topic or theme, there are problems with impact investing, too. Not all problems can be solved by investing, no matter how effective it is. The entities mentioned earlier are a part of the solution, but that does not mean that we should not try to do something meaningful by our own actions. Public sector regulations and laws, along with attitudes, are the foundation on which more impact-generating solutions can be built with impact investing.

The next topic is active stock picking, which is one of the best known parts of the investment world. The image of stock market analysts constantly analyzing companies is by no means false, but it can be misleading. What is stock picking really?

In its simplest form, a shareholder buys a stock from a listed company and sells it when he thinks the time is right. In reality, the process involves trading costs and other slowing down factors, but the core of stock trading is analysis and profit making. I want to sell the stock at a higher price than what I paid for it. How do I know which stock price is rising? How can I make an excess earning? How can I win the market? There are no simple answers to these, and the truth is that most investors are losing to the index in the long term.

However, there are many good things about active stock trading and it's definitely worth getting to know. Knowledge is power, and when you are ready to work hard and get to know different companies, it is possible to get good returns. If you are ready to put together a mosaic of pieces of information, analysis and calculations, it indicates that you want to truly understand the functioning of the market and the value of the company. No one can ever know everything, but finding the essential information and creating a logical whole will go a long way in replacing the missing pieces of the structure.

Recently, index investing has gained popularity at an accelerating pace and is, for many, the easiest way to start investing. An index investor cannot beat the market or make an excess earning, but investing in an index is safe and, at its best, does not take time. Because there are no free lunches, when index investing one loses the ability to capitalize on market sentiment or price distortions. An investor with discipline and good nerves can go countercurrent and is not accountable to anyone. Thus, he has the ability to monitor the performance of the market, find opportunities and avoid potential bad companies in the index.

In practice, an active shareholder can spend more time with various sources of information researching companies, interpreting past performance, and learning new things than trading. As the whole world moves forward, so do the companies on the stock exchange. In general, balancing between optimism and realism is a part of the daily life of an active investor. There are opportunities everywhere. There are disappointments everywhere.

Both topics have been popular for a long time and offer many possibilities. An active stock picker, compared to an index investor, has the ability to choose to his portfolio companies that create an impact and thus have the ability to support these solutions. By combining impact investing and stock picking, an investor can influence, learn, and especially act as they want on the matters that they find the most important.

More information on the topic:

Podcast: Money for the rest of us, 251: Impact Investing and Intentionality (available also on Spotify and Apple Podcasts)

Book: Capital in the Twenty-First / Thomas Piketty