Creating Wealth with Sanjay Guglani, Silverdale Funds, Singapore

This is particularly true, since it is universally observed that expenditure rises to meet the level of income. The best aspect of good investments is that they work for you 24x7 without any complaints, holidays, leaves, or provident fund contributions. However, as famously elucidated by Sir John Templeton, most people get carried away by four dangerous words, “This time it’s different” and hence take hasty decisions or get incapacitated by looming uncertainties caused by wars, inflation, or recession. In truth, you can safely mitigate most incoming investment risks through smart diversification.

At its core, diversification is the practice of spreading your investments so that the exposure to each type of asset is limited. It reduces portfolio risks significantly. Based on simplistic assumption, the chances of any single investment going sour are 50%. The chances of 2 investments going kaput at the same time are 25% (being 50%* 50%). Likewise, the probable chances of 3 investments going the wrong end up at the same time are 12.5%, and so on. Hence, if you make 13 investments, the chances of all those investments losing at the same time are less than 1%. To quote Nobel Laureate Harry Markowitz, “diversification is the only free lunch in the world.”

Most investors see the beauty of diversification through the appreciation of equity indices - which, for the most part are broad-based portfolios. For instance, an investment of INR 100 in the BSE Sensex at its inception in 1979 would today be INR 6 million, while a US $100 investment in an S&P 500 at its inception in 1927 would today be US $50 million. 

While investing in equities is indeed thrilling, some of the largest and savviest investors place much larger amounts in bonds than in equities. As a result, the fixed income (bonds) market is multiple times bigger than that of equities. There are three key reasons for it. 

Firstly, the probability of loss in quality bonds is very low. For instance, the probability of a 3-year Investment Grade (IG) bond defaulting is 0.41%, i.e., 1 in 244. Hence, if one were to have a well-diversified portfolio of 244 bonds, with one bond defaulting, the actual impact on the portfolio returns would not be material.

Secondly, fixed income securities are amenable to compound returns. As Einstein said, “compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.”

The power of compounding is legendary. Saving $2,000 per month at the start of one’s working age at 25 years until retirement at 65 years of age while earning just 3% p.a. results in a $1.85 million payout and earning 5% p.a. results in a $3.05 million payout on retirement.

Thirdly, in order to beat the index, most investors take concentration risk that is, allocating more weightage to a security than an index. Truth be told, adding a prudential amount of leverage to a highly diversified portfolio of bonds can provide enhanced returns with significantly lower risks.

For instance, if one has $100 and earns 4% interest p.a., the Return on Investment would be 4%. But if one borrows an additional $200 at 2%, the Return on Investment would be 8%.

Taking leverage comes with incremental risks of higher volatility, margin-call/fire-sale risks and hence, should be used with caution.

The best feature of fixed income investments is that, unlike equity, the returns from fixed income investments are reasonably known at the time of investment itself. There are numerous fixed income funds which can expose one to a diversified portfolio while using a prudential amount of leverage to generate enhanced returns.