1 Important Myth about Diversification Investors Should Know

Here’s a quick question about diversification: Would you consider having 50% of your portfolio being held in just five stocks prudent diversification?

If that’s not proper diversification for you, then you might want to take a long hard look at Singapore’s market barometer, the Straits Times Index (SGX: ^STI), if you think that an investment into it can offer diversification in the stock market.

It’s concentrated

That’s because, as of 26 January 2015, the top five shares within the Straits Times Index collectively accounted for 49.74% of the 30-component market benchmark. The quintet are namely DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX: O39), Singapore Telecommunications Limited (SGX: Z74), United Overseas Bank Ltd (SGX: U11), and Jardine Matheson Holdings Limited (SGX: J36).

Share Percentage of Straits Times Index ( as of 26 January 2015)
DBS 11.95%
OCBC 11.02%
SingTel 10.13%
UOB 9.51%
Jardine Matheson 7.13%
Sum 49.74%

Source: SPDR STI ETF’s website

Besides a concentration in names, we can see that Singapore’s market benchmark is also dominated by the banking trio of DBS, OCBC, and UOB. What this means is that investors in the index also face concentration risks due to a heavy reliance on just one sector – finance.

Hidden links

But that’s not all. There are a number of companies within the benchmark index that are inextricably linked to one another.

For instance, we have Sembcorp Industries Limited (SGX: U96) and Sembcorp Marine Ltd (SGX: S51). My colleague Stanley Lim had pointed out earlier today that the latter “contributed to slightly more than half of [the former’s] total profit and revenue in 2013.” Given this, any swoon in Sembcorp Marine’s business would likely be a kick in the gut for Sembcorp Industries too.

Yes, an investment into the Straits Times Index – through either of the two ETFs, namely the SDPR STI ETF (SGX: ES3) and the Nikko AM Singapore STI ETF (SGX: G3B) – can instantly accord an investor with a portfolio of 30 different companies. That can be taken to be adequate diversification for some.

But for others, the Straits Times Index may fall short of what it means to be properly diversified given the nature of its composition, as well as the links between different companies within it.

A solution

It used to be the case in Singapore where it was hard to construct diversified portfolios because investors were forced to invest in lot sizes of 1,000 shares each. That can represent a massive capital outlay for investors if they wanted to go with higher-priced shares like the banks or Jardine Matheson.

As a result, some investors may have been forced to go with the ETFs tracking the Straits Times Index in a bid to achieve low-cost diversification, even if those investors may not have agreed with the way the index is constructed.

But fortunately, things have changed recently. Last Monday, stock exchange operator Singapore Exchange Limited had finally reduced the lot size to 100 units. With that, it’d be much easier for investors to build a diversified portfolio by themselves without having to possess massive amounts of starting capital.

A Fool’s take

There can be many reasons for an investor to invest into an ETF tracking the Straits Times Index. But if adequate diversification is one of those reasons, then the investor ought to be fully aware of what he or she is stepping into.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.