eggs in one basket_2

Diversification: Expanding the Opportunity Set!

eggs in one basket_2
“ Diversification is your buddy!” – Merton Miller, Nobel Laureate


Diversification means different things to different people. Some people understand the timeless adage of “don’t put all of your eggs in one basket,” which strongly emphasizes the risk side of the investment coin. It could also be understood as the ability to expand our opportunity set. This takes a sober inquisition into our own limitations as investors. 

By now, it should go without saying it is extremely difficult to perpetually outperform the collective wisdom of all market participants. It is important to remind people that you are not just competing against a single object named “the market.” You are really competing against a network of millions of people with different pieces of information and estimates of future business prospects. Once you embrace this humility of our own limitations, you start to view the market and investing differently. Diversification becomes a very wide net in which you can cast over the benefits of capitalism around the world. It is a feeling of excitement versus that of fear.

There is a world of opportunity when it comes to investing in equities. Most investors are only familiar with the largest and most successful companies within the United States and are unaware that the U.S. only makes up approximately half of the entire investment universe. Outside of the U.S. are more than 10,000 companies spanning over 40 different countries. The exhibit below shows the investment universe in terms of market capitalization as of December 31, 2015.[i]

 

From a performance perspective, the “other” 50% of the investment universe has benefited investors over longer periods of time. For example, while the last 5-6 years has been challenging for the globally diversified investor, many investors also remember “The Lost Decade” for the S&P 500 (2000-2009). We remember headlines in newspapers constantly highlighting this lost decade for equity investors and us thinking, “which equity investors are you talking about?” For those investors who were globally diversified, this period of time was anything but a lost decade. IFA Index Portfolio 100 had an annualized return of 6.82%. $100,000 invested over this time period almost doubled ($193,437) while the S&P 500 actually lost a little bit of money over that time period.

 

A large part of this outperformance came from the risk premiums we are expected to be compensated for as investors; namely, small cap and value stocks. Emerging market stocks also had stellar performance. See the table below.


We have written before about the different cycles of domestic and international outperformance over time. The chart below gives a visual representation of these different cycles.

U.S. and International Stocks have Alternated as Global Market Performance Leaders
Trailing 12-month return differential, in percentage points

 

As equity investors, we want to be able to capture these benefits around the world. Again, we do not know with a high degree of certainty when one part of the world is going to outperform the other, so it is in our best interest to hold all of them.

Once we accept our limitations as investors, we can change our perception of investing from trying to exploit the illusion of how markets get things wrong and embrace how markets get things right. Diversification, while essential to the process of risk management, allows us to expand our opportunity set. Although many investors may feel uneasy investing in companies they are unfamiliar with, they can be confident in the fact that the vast mechanism that is the market has their backs. As long as investors require a positive return on the capital they supply and markets remain competitive, then prices will reflect a fair estimation of a positive expected return going forward. Because there is no certainty around a positive expected outcome, it is essential the investors expand their opportunity set, exercise discipline in the process, and focus on asset allocation versus security selection.



[i] Dimensional Fund Advisors. Why Should You Diversify? Dimensional Fund Advisors, LP. March 2016.