Why Should You Diversify?

Dec

18

December 18 , 2018 | Posted by Marc Wambaugh |

Why Should You Diversify?

As 2019 approaches, volatility has returned to the stock markets.  With that volatility comes a feeling of insecurity as investors watch their statement values go up and down.  During these times, the conventional wisdom is that diversification can help smooth out the ride.  However, US stocks have outperformed non-US stocks in recent years.

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 (a benchmark for developed international markets) returned 1.86% and the MSCI Emerging Markets Index returned 0.78%.  As US stocks have outperformed over the last several years, some investors have begun questioning the role of global diversification and whether or not it is beneficial to invest outside the US.

While there are many reasons why a US-based investor may prefer a home bias in their stock allocation, looking at the return differences over a five-year period is a relatively short time-frame and may result in missing opportunities that the international markets offer.  While the US markets have outperformed, it is much easier for an investor to continue investing money in the US, or buying high.  It is much harder to invest in the international markets when they haven’t provided significant returns, or buying low.  But in its simplest terms, this represents an opportunity to buy low and sell high.

The US stock market has enjoyed significant growth since the “Great Recession” of 2008.  But some investors tend to forget the “Lost Decade”.  We can examine the potential opportunity cost associated with failing to diversify globally by looking at the global market landscape from 2000-2009.  This period is often referred to as the “Lost Decade” by US investors since the S&P 500 Index recorded its worst ever 10-year performance with a total cumulative return of -9.1%.  However, looking beyond large US company stocks, conditions were more favorable for international investors as most equity asset classes outside the US generated positive returns over the same decade.  (See Exhibit 1)

Exhibit 1: Global Index Returns, January 2000-December 2009

S&P data © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. MSCI data © MSCI 2018, all rights reserved. Indices are not available for direct investment. Index performance does not reflect expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.

In 2017, the US stock market was up 21.2%.  That seems like a good return, but it ranked 16th when compared to the other developed countries’ stock markets.  The trouble is developing a systematic way to identify which countries will outperform others in advance.  Exhibit 2 illustrates the randomness in country stock market rankings over the past 20 years.

Exhibit 2: Equity Returns of Developed Markets

Source: MSCI country indices (net dividends) for each country listed. Does not include Israel, which MSCI classified as an emerging market prior to May 2010. MSCI data © MSCI 2018, all rights reserved. Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Hopefully this conveys how difficult it would be to create a strategy that relies on picking the best country.  Diversification means that in any given year, an investor’s portfolio is unlikely to get the best possible return, but it also means an investor is unlikely to get the worst possible return, too.  Experience has shown that diversification provides a means to achieve a more consistent outcome and helps reduce and manage the catastrophic losses that can be associated with investing in one stock or a single country.  Over longer periods of time, investors should benefit from consistent exposure in their portfolios to both US and non-US stocks.  As you can see from the exhibits above, you can’t predict when the returns are going to show up, but if you have exposure to the various markets, you can increase your likelihood of having a positive investment experience.

Source: Dimensional Fund Advisors LP.

Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.

There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision.