Bearings March 2016

Why Should You Diversify?

Equity markets have experienced a sharp decline to start 2016, leading some investors to reevaluate their asset allocation. As US stocks have outperformed developed ex US and emerging markets stocks over the last few years, some investors might consider reevaluating the benefits of investing outside the US. From January 1, 2010, through February 29, 2016, the S&P 500 Index had an annualized return of 11.66% while the MSCI World ex USA Index returned 2.26% and the MSCI Emerging Markets Index returned −2.28%. While there are many reasons a US-based investor may prefer a home bias in their equity portfolios, using return differences over the last few years as the sole input into this decision may result in missed opportunities that the global markets offer. We recognize that stocks in non-US developed and emerging markets have delivered disappointing returns relative to the US over the last few years. However, it is important to remember that:

  1. International stocks help provide valuable diversification benefits.
  2. Recent performance is not a reliable indicator of future returns.
There’s a world of opportunities in equities

The global equity market is large and represents a world of investment opportunities. As shown in Figure 1, nearly half of the investment opportunities in global equity markets lie outside the US. Non-US stocks, including developed and emerging markets, account for 48% of world market cap and represent more than 10,000 companies in over 40 countries.

A portfolio investing solely within the US would not be exposed to the performance of those markets.

The lost decade

We can examine the potential opportunity cost associated with failing to diversify globally by reflecting on a recent period from 2000-2009. During this period, often called the "lost decade," the S&P 500 Index recorded its worst ever 10-year performance with a total cumulative return of -9.1%. However, when you look beyond US large cap equities, conditions were more favorable for global equity investors as most equity asset classes outside the US generated positive returns over the course of the decade (see Figure 2). Expanding beyond this period and looking at performance for each of the 11 decades starting in 1900 and ending in 2010, the US market outperformed the world market in five decades and underperformed in the other six1. This further reinforces why an investor pursuing the equity premium should consider a global allocation: By holding a globally diversified portfolio, investors are positioned to capture returns wherever they occur.

Pick a country?

Are there systematic ways to identify which countries will outperform others in advance? Figure 3 illustrates the randomness in country equity market rankings (from highest to lowest) for 19 different developed market countries over the past 20 years.

This graphic conveys how difficult it would be to execute a strategy that relies on picking the best country and the resulting importance of global diversification.

In addition, concentrating a portfolio in any one country can expose investors to large variations in returns. The difference between the best- and worst-performing countries can be significant. For example, since 1996, the average return of the best-performing developed market country was 37.5%, while the average return of the worst-performing country was -15.7%.

Over the last 20 calendar years, the US has been the best-performing country twice, and the worst performing once. Diversification implies an investor’s portfolio is unlikely to be the best or worst performing, but diversification provides the means to achieve a more consistent outcome and most importantly helps reduce and manage catastrophic losses that can be associated with investing in just a small number of stocks or a single country.

A diversified approach

Over long periods of time, investors can 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 in the long term, they may perform quite differently over shorter cycles. While the performance of different countries and asset classes will vary over time, there is no reliable evidence that performance can be predicted in advance. An approach to equity investing that uses the global opportunity set available to investors can provide both diversification benefits as well as potentially higher expected returns.

 1 Annual country index return data from the Dimson-Marsh-Staunton (DMS) Global Returns Data, provided by Morningstar, Inc.