Opinion: The importance of diversification

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on November 12, 2018 - November 18, 2018.
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As a journalist who writes about investing, I have direct access to private bankers, fund managers and financial planners. During interviews, I ask them questions and jot down important points as they share their views. If there is one word they mention often at these sessions, it is “diversification”.

The term was new to me when I joined the financial journalism fraternity four years ago. Whenever they said the word, I would look straight into their eyes, give them a serious nod and scribble it in my notebook.

However, as time passed, it would carry much less weight. It was merely a word or a concept that every investor has to learn at the beginning of their investment journey. So, when my interviewees mentioned this word again, I would not think too much about it.

When I wrote articles on peer-to-peer (P2P) financing last year, the word popped up again and again. There are currently six licensed P2P financing platforms in the country and the operators told me during the interviews that diversification was very important. I would nod and think, “Well, who wouldn’t know this already?”

After those articles were published, I decided to put some money in one of those P2P financing platforms. When I did so, I did not forget the concept of diversification. I transferred RM3,000 to the platform’s bank account and subsequently invested RM1,000 each in three investment notes.

I was pleased after everything was done. After all, didn’t it show that I understood the concept well and executed it perfectly?

The three investment notes were 12-month business term loans that offered a simple annual interest rate of more than 10%, excluding fees. The potential return was attractive and I was pleased. But I also started to feel impatient as I saw how slowly the money was flowing into my account.

Why? Well, investors only get 1/12th of their principal and return each month. It is only after a year that they get back their capital plus interest.

To put this into perspective, if I invest RM1,000 in a 12-month investment note that offered a simple interest rate of 12%, I would get RM93.33 (RM83.33 + RM10) each month. This is unlike investing in equities, where investors get the thrill of seeing the share prices move up or down every minute, or even every second.

Some of the platforms have introduced invoice financing notes, which have shorter tenures but equally attractive returns. The tenures range from three to six months while the simple interest rate is about 11% per annum. However, unlike term loan financing — which gives investors a portion of their principal and return every month — invoice financing notes only give investors a lumpsum at the end of the tenure.

I quickly snapped up some of these newly issued invoice financing notes and was excited to see a larger sum of money flowing into my account after three months. I did the calculations. If I invested RM1,000 in a three-month invoice financing note with a simple interest rate of 12% per annum, I would receive RM1,030 after three months.

What a difference! Instead of receiving RM93.33 every month, I now get RM1,030 after three months. And if this is not good enough, I could increase my investment amount from RM1,000 to, say, RM5,000 and I would receive RM5,150 after three months.

This is exactly what I did. I slowly increased my investment in several invoice financing notes from RM1,000 to RM3,000 each. The largest amount I invested in a note was RM5,000. I was a happy boy — until a default happened.

The first publicly known default happened in August and I was one of the investors. However, I considered myself lucky because the note was an 18-month term financing loan in which I had only invested RM1,000. The default happened towards the end of its tenure. So, assuming that the subsequent payments cannot be collected from the issuer of the note, I would lose only a few hundred ringgit.

Nevertheless, my heart sank a little when I received the email notification of the default. It was only at that point that I truly understood what diversification meant.

Perhaps, deep down, I did not really believe in the benefits of this fundamental strategy. Or maybe I did, but I got carried away by greed and failed to execute it consistently. I totally forgot about the default risk and assumed that it would not happen. And if it did, I would not be one of the unlucky investors.

The lesson I learnt is a simple one: Remember to diversify your investments, especially when investing in asset classes that carry higher risk. And when your private banker or financial planner tells you how important diversification is, take him seriously.