Diversification Means Saying Sorry

One of the oldest adages in investing is to diversify. “Don’t put all of your eggs in one basket.” On the flip side, being diversified means you always own something that underperforms. I am not the first person to write that “diversification means always having to say you’re sorry”. For more great articles on the topic see here and here. But it is a topic worth revisiting as U.S. stocks appear to be outperforming international and emerging markets again this year.

Since the end of the market drawdown in 2009, the S&P500 Index has outperformed the MSCI EAFE Index by 7.40% annualized. That is a very long time for investors to endure such a wide gap in performance.  A child born in 2009 is currently in the 3rd grade, learning multiplication tables and world geography. I saw a documentary about young golf phenoms last year, and many of these champions were under the age of 10. A lot can happen in our lives while we wait for diversification to work.

While the past nine years have been rough for international stocks, take a look at the decade prior to the financial crisis. The chart below illustrates annual returns for the S&P500 Index, international developed stocks, and emerging market stocks between 1998 and 2007. In 7 out of 10 years, and for 6 years in a row, international stocks outperformed the U.S. The outperformance of emerging markets is even more dramatic. This was a very painful time not to be invested in stocks outside the U.S. We don’t know what the next decade holds, but it’s not out of the realm of possibility for international stocks to go on another long run of outperformance.

International Developed Stocks represented by the MSCI EAFE (net div.) Index. Emerging Market Stocks represented by the MSCI Emerging Markets Index. 

My favorite reminder of why to own stocks outside the U.S. is illustrated in the map below. U.S. stocks comprise 52% of the global market cap. By eliminating international and emerging market stocks, an investor is leaving half of the global market out of his portfolio. That is an enormous overweight position to take in the U.S. As the emerging economies in China and India continue to grow, the size of their stock markets will become a larger portion of the global pie. The opportunity set outside the U.S. is too large to ignore.

 

Source: Dimensional Fund Advisors

The goal of diversification is to eliminate unnecessary risks. Risk is inherent in investing. Investors must be willing to endure the ups and downs of security prices in order to earn the market return. This is a natural phenomenon that is required for capital markets to work.

But unnecessary risks can be avoided. Unnecessary risks include a host of decisions including, but not limited to; single securities, sector bets, reaching for yield, and failure to invest in almost half of the world’s stock market. Unnecessary risks can lead to periods of excess performance, but they are not a reliable strategy for the long term.

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