Why you should not invest in the STI

Assume there are only two stocks in the world, Stock A and Stock B from Company A and B respectively. Company A is big, owning 90% of the workd's output, while Company B owns the other 10%.

If you were to invest into each company, would you: (a) buy Stock A only, (b) buy stock B only, (c) buy both stocks in the proportion of 90-10, or (d) buy both stocks in equal weightage?

Different types of investors

If you went for Stock A, you are likely to invest in blue-chips. These companies are stable and give out dividends. Similarly, they don't grow much since they are already so big.

If you picked Stock B, you are more likely to be a growth investor. Small capitalization stocks have traditionally outperformed large capitalization stocks and the market but they also come with greater risk of being completely bankrupt.

If you pick Stock C and D together, you are an index investor, or you just can't make up your mind! Even if you index invest, there are two ways of doing so.

The two ways of investing

If you went for method C, it is the purest form of index investing. You are basically investing in the economy of the world, because 90% of the world's economy comes from Company A while the other 10% comes from Company B. Investing them in a 90-10 proportion means that you are investing in the economy of the world.

If you chose Method D, what you're actually doing is a deviation of index investing. This approach is also known as an equal-weighted approach as compared to the capitalization-weight approach. This approach has seen increasing popularity but I would say it's not the purest form of index investing.

Why is there a correct way of index investing?

Let's look at Method D. By doing so, do you find that you are actually betting that Company B will perform better than the world economy? You are 5 times more exposed to the performance of Company B than that of the world.

Explanation: a movement of Company B affects 10% of world economy, but 50% of your portfolio.

To be a truly index investor, whose motives are to reduce all forms of unsystematic risks, the only way is to buy a world index fund based on a capitalization-weighted methodology.

Why you shouldn't invest in the STI

The total market capitalisation of the STI was $263 billion in 2014 and the world market capitalisation was $68 trillion, or $68,000 billion. In this regard, the STI constitutes 0.39% of the world's market capitalisation.

Evidently, by investing only in the STI, you are exposed to geographical risk. The right way to invest is to pick a world index fund which will then represent Singapore correctly in terms of market capitalization. Doing so will eliminate all unsystematic risks.
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