Diversification. That’s all many financial advisers recommend. They believe diversification reduces market risks and they are correct. With enough diversification, a portfolio’s performance will closely track the performance of an index.
The problem with diversification is that a widely diversified portfolio will closely track the performance of an index. If the index declines, the portfolio will lose value. This is obvious, but many investors seem surprised that diversification isn’t much help in a bear market.
To overcome this problem, many advisers suggest investing in global markets. A noted CNBC commentator often yells, “There’s always a bull market somewhere.” If this is true, then global diversification should be able to help investors reduce losses in a bear market.
One major brokerage firm explains, “If you don’t invest globally, you’re not only narrowing your opportunity set but ignoring an important tool to help manage volatility. Though not without risk, a global allocation provides diversification benefits and is one of the underpinnings of modern wealth management.”
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We always prefer to look at data instead of blindly accepting marketing. Let’s look at the data to determine whether global diversification helps.
Financial advisers also tell us we should ignore the ups and downs in our portfolio because in the long run, stocks always go up. They point to US stock market trading as their example. In the chart below, we compare the United States to France for the long term. Over the 145 years of this comparison, French investors suffered losses after inflation in government bonds and bills.
Source: Global Financial Data
Remember that government securities are considered risk free. Looking at data, we see that is not always true. You might think France is a special case and that we cherry picked this example. The next charts shows returns from 1900, or when available, for a number of countries.
It’s important to note that the United States outperformed the global averages since 1900.
It’s widely believed that international diversification can increase performance. In the long run, many of the world’s markets have been poor investments. We look at global markets and show that passive strategies may not work very well. Since 1900, only Australian stocks have beaten US stocks. Bonds in Austria, Germany, Italy and Japan have lost money.
From the data, there appears to little reason to consider investing in markets outside the United States if you are a US-based investor. The returns, lower in almost all cases, do not appear to justify the risks.
The reason for the growth in US stocks is the fact that US economy grew throughout the twentieth century. Most of the other countries in the world suffered from the disruption caused by world wars or smaller conflicts. The US did not see its economic base destroyed as France did in both world wars. Economic infrastructure in most of Europe and Japan was destroyed in the second world war.
Data, again, puts these observations into perspective. In 1899, the United Kingdom was the world’s largest stock. The London Stock Exchange accounted for about 25% of global stock market capitalization at that time. The US market accounted for 15% of the world’s market cap.
In 2016, the United States accounted for more than 53% of the world’s market cap. The UK accounted for just 6.2% of the global stock market. Japan was second to the US with 8.4%.
The question for investors is whether or not the United States will continue to be a global leader in the twenty first century.
Many analysts point to the ascendancy of China as an economic power. Yet, China accounted for just 2.2% of the global stock market capitalization at the end of 2016. China’s economy is large and growing but its financial markets are not yet mature. China is best thought of as emerging market.
Emerging markets are a hot investment theme. The fact that they are emerging implies that they are growing. They are generally smaller countries and it is easier to grow rapidly from a small base than it is from a large base. The idea seems to be that if China, India and other countries can grow three times as fast as the US, or even more, they must be good investments. The long term data for that investment thesis is shown in the next chart, also from the Credit Suisse Global Investment Returns Yearbook. Larger, developed markets are the blue line. The red line shows the performance of the smaller, faster growing emerging markets.
In the long run, developed markets have outperformed the emerging markets. This demonstrates that developed markets are more stable in the long run, with less war and political instability. Emerging markets can suffer from a variety of problems, lack of roads or access to reliable electricity, for example, that limit their growth potential in the short run.
Data doesn’t fully support the idea that global diversification will improve investment returns. So, where did this idea come from? As in many cases, the idea is grounded in old data. In the next chart, we show the degree of correlation between emerging and developed markets over time. Correlation defines the mathematical relationship between two variables. Correlations range from -1.0 to +1.0. Values of -1 are perfectly inverse and investments in assets with perfect inverse correlations would provide diversification. Value of 0 indication no correlation exists and the relationship is essentially random. Values of +1 are perfectly correlated and move in line with each other. Investments with correlations close to 1 do not offer diversification.
Over time, the correlation between emerging markets and developed markets has been rising. This indicates that at one time, emerging markets could help diversify a portfolio invested in developed markets. But, that relationship has changed and emerging markets no longer provide the same degree of diversification.
This is one of the most common problems in the investment world. When something becomes well known, the markets change. Small cap stocks no longer significantly outperform in January as they once did, for example. That pattern actually disappeared almost as soon as it was discovered. The reason it disappeared is probably because it was published. As more investors learned of the idea, they tried to benefit from it. Eventually someone decided to invest in December to beat the crowd in January. Then, someone realized they could get better results by investing in early December. Now, the January effect tends to play out in the fourth quarter of the previous year as traders try to get ahead of each other.
The same is true of diversification into foreign markets. As the idea became more popular, more money poured into foreign markets. Much of it was indexed because the cost of doing research into individual securities in foreign markets can be high. These new investments have, in effect, eliminated the very investment objective they were pursuing. Now, instead of behaving differently from developed markets, emerging markets act almost the same way as developed markets. This is because both markets are reacting to money flows from large investors.
Large investors chase returns. When markets are rising, they buy. This leads to further gains and further investments. When markets turn down, they sell. Their buying and selling is now done around the world, often with allocations to different countries based on their share of global market cap. That results in a high degree of correlation between global markets and explain why we no longer enjoy the benefits of diversification.
The best trading strategy for investors may be to focus on their home country. Use a sound and logical active strategy and follow the strategy with discipline. This could allow them to beat the experts, even while ignoring the conventional wisdom to diversify around the world.