Why Should I Diversify My Portfolio?

Winter 2019

With the S&P 500 outperforming non-U.S. stocks in recent years, some investors have wondered, “Why should I hold anything but the S&P 500?” This article addresses that question, and reminds us of the role that global diversification plays in an investment portfolio.

For the five-year period ending October 31, 2018, the S&P 500 Index had an annualized return of 11.34%, while international stocks (via the MSCI World ex USA Index) returned 1.86%, and emerging markets (via the MSCI Emerging Markets Index) returned 0.78%. As U.S. stocks have outperformed international and emerging markets stocks over the last several years, some investors might be reconsidering the benefits of investing outside of the U.S.

While there are many reasons to prefer a slight home-country bias in your equity allocation, using return differences over a relatively short period as the sole input into this decision may result in missing opportunities that the global markets offer. While international and emerging markets stocks have delivered disappointing returns relative to the U.S. over the last few years, it is important to remember a few key points:

• Non-U.S. stocks provide a valuable diversification benefit.
• Recent performance is not an indicator of future returns.

THERE’S A WORLD OF OPPORTUNITY IN EQUITIES

The global equity market is large and represents a world of investment opportunities. As shown in Exhibit 1, nearly half of the investment opportunities in global equity markets lie outside the U.S. Non-U.S. stocks, including developed and emerging markets, account for 48% of world market capitalization¹ and represent thousands of companies in countries all over the world. A portfolio investing solely within the U.S. would not be exposed to the performance of those markets.

Exhibit 1. World Equity Market Capitalization

THE LOST DECADE

We can examine the potential opportunity cost associated with failing to diversify globally by reflecting on the period in global markets from 2000 to 2009. During this period, often called the “lost decade” by U.S. investors, the S&P 500 Index recorded its worst-ever 10-year performance with a total cumulative return of –9.1%. However, looking beyond U.S. large cap stock, conditions were more favorable for global equity investors as most equity asset classes outside the U.S. generated positive returns over the course of the decade, as shown below.

Exhibit 2. Global Index Returns, January 2000 – December 2009

S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. MSCI data © MSCI 2019, 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.

Expanding beyond this 10-year period and looking at performance for each of the 11 decades starting in 1900 and ending in 2010, the U.S. market outperformed the world market in five decades and underperformed in the other six.² This further reinforces why an investor pursuing the equity premium (the expected higher return from investing in stocks over bonds and cash) should consider a global allocation. By holding a globally diversified portfolio, you are positioned to capture returns wherever they occur in the world.

PICK A COUNTRY?

Are there systematic ways to identify which countries will outperform others in advance? Exhibit 3 illustrates the randomness in country stock market rankings (from highest to lowest) for 22 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-performing country.

In addition, concentrating a portfolio in any one country can expose you to large variations in returns. The difference between the best- and worst-performing countries can be significant. For example, since 1998, the average return of the best-performing developed market country was approximately 44%, while the average return of the worst-performing country was approximately –16%. Diversification means your portfolio is unlikely to be the best or worst performing relative to any individual country, but diversification also provides a more consistent outcome, and more importantly, helps reduce and manage catastrophic losses that can be associated with investing in just a small number of stocks or a single country.

Exhibit 3. Equity Returns of Developed Markets

OUR GLOBALLY DIVERSIFIED APPROACH

Over long periods of time, investors may benefit from consistent portfolio exposure to both U.S. and non-U.S. equities. While both asset classes offer the potential to earn positive expected returns in the long run, they may perform quite differently over short periods.

There is no reliable evidence that the performance of different countries can be predicted in advance. An approach to investing that uses the global opportunity set can provide diversification benefits along with potentially higher expected returns.

Footnotes and Sources

1. The total market value of a company’s outstanding shares, computed as price times shares outstanding.
2. Source: Annual country index return data from the Dimson-Marsh-Staunton (DMS) Global Returns Data, provided by Morningstar, Inc.

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.