Monday, October 31, 2016

The 12% Limit

There was an interesting conversation on investments that I had with a friend of mine. He has a simple equity-bond portfolio and the weightage is 60-40 respectively. As we chatted on we started to go into the nitty gritty of his portfolio, and what he revealed next came as a surprise to me.

His portfolio is consisted of only two individual companies at the equity portion, and a corporate bond making up the entirety of his bond part.
When I asked him further on the choice of his components, he said he was familiar with them and deemed them as safe investments.


Using my friend's portfolio as an example, let us assume his two company equities are Company A and Company B, and the corporate bond is called Bond Z. The ratio of holdings between Company A, Company B and Bond Z is 30 : 30 : 40 respectively, based on his 60-40 allocation.

There are a number of risks inherent in his portfolio. First on the list would be bond default risk; the worst case scenario is a total default of Bond Z, and this would mean a 40% wipeout of his portfolio.

Next up is market risk; if the price of Company A goes down by half, it would translate to a 15% overall loss for the portfolio.

The doomsday scenario would be the complete price collapse of Companies A and B, and Company Z which issues Bond Z, during a market downturn. It did happen during the 2008-2009 Global Financial Crisis. That is a scary thought.

In fact recently some stable companies' share prices were taking a dive, and the default of corporate bonds were making financial news headlines in the past few months. The risks are real.

Diversification and the 12% Limit

This is where the importance of diversification comes in. As often mentioned in my ebook, diversification helps to reduce risks. By having more individual equities, bonds and REITs within a portfolio means the risks are spread across, and a collapse or default of one company or REIT would be less painful.

As a guideline, I would recommend that an individual equity/bond/REIT do not exceed 12% of the portfolio value. In the event of a wipeout, 12% would be the maximum loss you could bear.

Why 12%, you may ask.

I derive the 12% guideline from the holdings of the Straits Times Index, or better known as the FTSE STI. If you look at the factsheet1, the three largest components are in the range of 11.xx%. So to round it off, I made it 12%.

Exceptions to the 12% Limit

There are a few asset classes and investment vehicles that are exempted from the 12% limit. Exchange Traded Funds (ETFs) are one of them; after all, they are made up of different individual equities/bonds/REITs/commodities. The only risk of concern would be the counterparty risk against the ETF provider, but that is low compared to the risks of holding Company A, Company B and Bond Z only. The others would be physical commodities (e.g. physical gold and silver) and cash.

Back to My Friend

I had told him basically what I had posted above. Good thing is his portfolio is still healthy at the moment, and he would be exploring other equities and bonds, as well as ETFs.

1 – FTSE Russell. Straits Times Index. 30 September 2016. (accessed 31 October 2016)

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