“The math of diversification makes sense. It’s the psychology of diversification that is muddled. The path forward is not to rethink the former, but to accept and think through the latter. It is not a smart alternative to concentrate one’s portfolio in what one predicts will be the hot dot. At the same, it’s also unfair to ourselves to ignore that diversification is often a bitter pill to swallow — even when it’s good for us.”
Diversification is viewed by many as one of the cornerstones to portfolio construction. The don’t put all your eggs in one basket approach provides investors with the ability to invest in markets filled with uncertainty. Diversification is often referred to as the only free-lunch provided by Wall Street—it can reduce many investable risks without having to sacrifice potential returns.
Because markets move in cycles, you should generally own some assets that are lagging while others are outperforming. If everything is up at the same—you are probably not properly diversified. Prudent investors diversify because they recognize the impossibility of consistently predicting over the long-term which asset classes will outperform—and when they will perform. Proper diversification helps you reduce volatility and generally avoids upside/downside extremes.
A globally diverse investment portfolio is sound wealth management. However, the theories and principles of diversification are often tested. Most investors know that U.S. and foreign stocks go through relative performance cycles—which can be at times, long-lasting. Patience and discipline—informed by a knowledge of market history—are necessary.
How do you react during extreme periods of over/under performance between U.S. stocks and non-US stocks (Note: since 2007 US stocks are up nearly 92 percent while International/Emerging Markets stocks are up 4.7 and 19.2 percent respectively)? Do you stay the course—or conform to recency bias and heavily tilt your portfolio to chase the performance of the most recent winners? Without a plan—it is difficult to know what to do.
By owning a globally diversified equity portfolio, you can gain access to a much broader investment opportunity set. Per Vanguard—in 2015, the total developed world stock market capitalization was $35.7 trillion, with $16.8 trillion representing international (outside of the U.S.) stock market capitalization. A source of returns for non-U.S. portfolios is investing in other currencies besides the U.S. Dollar. Non-U.S. equity returns are impacted by fluctuations in exchange rates. A decline in the U.S. Dollar, all else being equal, should increase the rate of return on an investment in an overseas company.
Looking at actual market data, we can show that a globally diversified portfolio will generally help boost the longer-term risk/return dynamics. This is highlighted by the annualized return of a globally diversified portfolio at 10.9 percent vs. a 100 percent US stock portfolio (S&P500) of 10.3 percent (1970-2016). Starting with the same $1,000,000 portfolio, an investor would now have $128,915,089 with a globally diversified portfolio vs. $100,486,452 (note the power of compounding returns).
At OJM Group, as much as we seek to identify compelling long-term investment opportunities, we also aim to be cognizant of, and assess the impact of what could go wrong, and what the potential downside could be for all opportunities. Our goal is to construct diversified portfolios that have the most attractive return profiles given the risks and opportunities. These portfolios are designed to be resilient across a range of potential macro scenarios, rather than heavily reliant on one outcome playing out.
When our analysis suggests an asset class may have an attractive return potential relative to its risk, we may tactically tilt the portfolio in that direction. However, we will still maintain broad diversification to various asset classes and risk factors as a primary portfolio risk management tool. Our approach reflects what we think is a healthy humility and respect for the inherent unknowability and uncertainty of the future (in general, and specific to financial markets and economies). As investment managers, we aim to be realists, not pessimists, when it comes to assessing the potential range of outcomes, both positive and negative, as objectively as possible.
We also believe it is important to educate and prepare our clients for risks we think have a reasonable chance of playing out, and would have significant impact on their portfolios. For example, we believe that the current themes coming from President Trump on international trade, if eventually implemented as policy, might impact U.S. stocks negatively more than foreign ones. U.S. corporations have benefited tremendously from free trade and globalization via access to cheaper labor as well as more efficient and cost-effective global supply chains. This can be seen in the historically high margins U.S. companies achieved in the past decade-plus. They bet big on globalization and open trade and may have more to lose as a result. The point is—holding a global portfolio introduces the potential for additional returns due to currency exposure.
It is how we are wired. We would rather prepare you for potential negative shocks and be pleasantly surprised should the risks not play out—rather than naively advise you to expect only the most positive outcome no matter what the environment. BE wary of any advisor unwilling to discuss risks and the potential for negative outcomes.
Everything is malleable. As market prices, valuations, and fundamentals change, our views and positioning may change. And that is one additional area of great opportunity for our portfolios. We are optimistic (rationally so, we believe) that markets will be volatile in the future. And when market prices and underlying asset values diverge due to the inevitable and enduring cycles of investor herd behavior driven by greed and fear (or excessive optimism and pessimism), our disciplined, patient, tactical, long-term investment approach will be in prime position to take advantage of those cycles.
 Portnoy, Brian (March 9, 2015); Diversification Means Always Having to Say You’re Sorry. Accessed via url on Feb. 9, 2017: http://www.forbes.com/sites/brianportnoy/2015/03/09/diversification-means-always-having-to-say-youre-sorry/4/#1d44df2714e0