Updated: Jan 18
Why would someone want to have a portfolio that's globally diversified? We're Americans and we're patriotic, so why not invest everything in the US? Besides that, the US stock market has been rocking for the last few years.
Advantages of Global Diversified Portfolios
While there are many reasons why a US-based investor may prefer a degree of home bias in their 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 US over the last few years, it is important to remember that:
1. Non-US stocks help provide valuable diversification benefits.
2. Recent performance is not a reliable indicator of future returns.
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 US. Non-US stocks, including developed and emerging markets, account for 46% of world market capitalization and represent thousands of companies in countries all over the world. A portfolio investing solely within the US would not be exposed to the performance of those markets.
Figure 1. Percent of World Market Capitalization as of December 31, 2019
The Lost Decade Example
We can examine the potential opportunity cost associated with failing to diversify globally by reflecting on the period in global markets from 2000–2009. During this period, often called the “lost decade” by US investors, the S&P 500 Index recorded one of its worst 10-year performances with a total cumulative return of –9.1%. However, looking 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 Exhibit 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 six (note i below.) 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.
Figure 2. Global Index Returns. Jan 2000-Dec 2009.
Which country will do best this year?
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 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 country and the resulting importance of diversification.
Figure 3. Equity Returns of Developed Markets. (see note 3 below.).
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 2000, the average return of the best-performing developed market country was approximately 32%, while the average return of the worst-performing country was approximately –15%. Diversification means an investor is unlikely to have the best- or worst-performing portfolio relative to any individual country, but diversification also provides a means to achieve 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.
A Diversified Approach
Over long periods of time, investors may 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 run, they may perform quite differently over short periods. While the performance of different countries and asset classes will vary over time, there is no reliable evidence that this performance can be predicted. An approach to equity investing that uses the global opportunity set available to investors can provide diversification benefits as well as potentially higher expected returns.
See "Why you Should Diversify" article linked here.
Note i: Source: Annual country index return data from the Dimson-Marsh-Staunton (DMS) Global Returns Data, provided by Morningstar, Inc.
Notes for figures above.
1. As of December 31, 2019. Data provided by Bloomberg. Market cap data is free-float adjusted and meets minimum liquidity and listing requirements. China A-Shares that are available for foreign investors through the Hong Kong Stock Connect program are included in China. 30% foreign ownership limit is applied to China A-Shares. For educational purposes; should not be used as investment advice.
2. S&P data © 2020 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. MSCI data © MSCI 2020, 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.
3. 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 2020, 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.
Disclaimer: Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.