Diversify to Reduce and Manage Catastrophic Investing Losses
Why Should You Diversify?
You work hard for your money. You want your investments to grow so you can live a life of freedom from worry, fulfillment, and love. When the financial markets are up one day and down the next, investors often feel tempted to double down on what they believe performed well in the past. Historical data suggests that by diversifying globally investors can hedge against volatile market highs and lows, and reap potential long-term benefits.
2019 is rapidly approaching, and with US stocks outperforming non-US stocks in recent years, many investors have again turned their attention toward the role that global diversification plays in their investment portfolios. For the five-year period ending October 31, 2018, the S&P 500 Index had an annualized return of 11.34% while the MSCI World ex USA Index returned 1.86%, and the MSCI Emerging Markets Index returned 0.78%. Since US stocks have outperformed international and emerging markets stocks over the past several years, some investors might be wary of investing outside the US.
There are many reasons why a US investor may have a degree of home bias in their equity allocation. However, when you compare return differences over a relatively short term as a basis for increasing US-based stocks in your portfolio, it may result in missing opportunities that the global markets offer. While international and emerging markets stocks have delivered disappointing returns relative to the US over the last few years, it is important that you consider:
1) Non-US stocks help provide valuable diversification benefits.
2) Recent performance over the short-term does not reliably predict future returns.
Equities Offer a World of Opportunity
The global equity market represents diverse investment opportunities because it is so large. As shown in Exhibit 1, almost half of the investment opportunities in global equity markets lie outside the US. Non-US stocks, including developed and emerging markets, represent thousands of companies in countries all over the world. A portfolio invested solely within the US will not gain exposure to the performance of those markets.
The Lost Decade Was a Painful Lesson
By looking at global markets from 2000–2009, we can study the potential opportunity cost associated with failing to diversify globally. During this period, often called the “lost decade” by US investors, the S&P 500 Index experienced its worst ever 10-year performance with a–9.1% total cumulative return. However, circumstances were more favorable for global equity investors because the majority of asset classes outside the US generated positive returns over that period. (See Exhibit 2) By looking at performance for each of the 11 decades beyond this period, starting in 1900 and ending in 2010, the US market outperformed the world market in five decades and underperformed in the other six.1 Again, this reinforces how holding a globally diversified portfolio might position investors to capture returns wherever they occur.
Exhibit 2: Global Index Returns January 2000–December 2009
“ You always hear, ‘Never put all your eggs in one basket.’ Nothing rings more true when it comes to the investments in your portfolio.” –Greg, Hammond, CFP®, CPA
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Which Countries Perform Best?
Investors expose themselves to large variations in returns by concentrating a portfolio in any one country. There are significant differences between the best and worst performing countries. For example, since 1998, the best performing developed market country’s average return was approximately 44%, while the worst-performing country’s average return was approximately –16%. Diversification makes it unlikely that an investor’s portfolio will fall into the extremes of best or worst, relative to any individual country. It also helps create a more consistent outcome, and more importantly, helps reduce and manage catastrophic losses that can be associated with investing in only a small number of stocks, or a single country.
So, how can investors identify which countries might outperform others in advance? Exhibit 3 illustrates the randomness in equity market rankings by country from 1998 to 2017. It shows how it would be nearly impossible to execute a strategy that relies on picking the country that best performs, and reinforces the importance of diversification in an investment portfolio.
Exhibit 3: Random Market Results
A Diversified Approach
Over long periods, investors may benefit from consistent exposure in their portfolios to both US and non US equities. While both asset classes offer the potential to earn positive expected returns over the long term, they may perform quite differently over short periods. While the performance of different countries and asset classes varies over time, there is no reliable evidence that investors can predict this performance in advance.
In summary, we find that a globally diversified approach to investing provides diversification benefits, eases risk and has the potential to generate higher than expected returns.1. Source: Annual country index return data from the Dimson-Marsh-Staunton (DMS) Global Returns Data, provided by Morningstar, Inc.
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About Greg Hammond, CFP®, CPA
Greg Hammond is the chief executive officer of Hammond Iles Wealth Advisors, and co-founder of Planned Giving Strategies®. Greg leads a team of professional financial advisors providing customized wealth management and investment solutions for high-net-worth individuals, families, companies, and charitable organizations across the U.S.