Global Point

The Importance of Global Diversification

Global Point

Investing, in a nutshell, is really about dealing with risk and uncertainty.  While most of us like to focus on the return aspect of investing, it is important to remember that return is only one side of the “investment coin.” Risk and uncertainty are on the other side and you cannot have one without the other, generally speaking.

When it comes to dealing with uncertainty, investors sometimes fall into the trap of focusing solely on investments they are “familiar” with. For U.S. investors, names like Apple, Exxon Mobil, General Electric, and Johnson & Johnson have become household names. You buy their products and trust their brand. The problem with focusing solely on the familiar is that you are missing out on potential returns that can be found in unfamiliar names or regions around the world.

Given the recent outperformance of securities outside the U.S., I thought it was timely to review the benefits of global diversification.

Global Opportunity Set

If we were to look solely at the global market capitalization (i.e. the value of global enterprise), you can see that almost one-half of the value is found outside of U.S. borders.

The Lost Decade

Diversification into smaller, less well-known companies as well as expanding the opportunity set into international and emerging markets can be extremely beneficial. When the U.S. doesn’t do so well, there could be an opportunity to earn a positive return by investing in other countries. To give a most recent example, the 2000’s were considered “The Lost Decade” for investors. The S&P 500 had an annualized return of -0.95% over that 10 year period. But it wasn’t a “Lost Decade” for investors who were globally diversified. In fact, IFA Index Portfolio 100, our 100% stock portfolio, generated a 6.82% annualized return over the same time period.

In general, the last 5 years have been great for investors, although it has been a trying period for globally diversified portfolios. IFA Index Portfolio 100 has trailed the S&P 500 by 2.66% per year. The rest of the world has not been able to keep up with the U.S. and many investors may start asking the question of, “why do I need international diversification?” “Why don’t I just stick with what I am familiar with?”

Historical Perspective

An advisor's job is to take this very narrow perspective and try to broaden it out so investors can get a complete picture of the ramifications of their asset allocation decisions. The fact of the matter is that we have historically seen this “seesaw” effect in terms of which part of the world was the top performer going back to the 1970s.

As you can see, the rest of the world (MSCI World ex US) outperformed the U.S. (S&P 500) during the 1970s, 1980s, and 2000s while the U.S. was dominant in the 1990s and so far in the 2010s.

Can You Pick the Next Winner?

In reality, we have no idea which part of the world is going to outperform. The chart below depicts IFA Indexes, which include equities from around the world, ranked by performance over the 20-year period ending in 2016. Can you pick the next winner?

Conclusion

Discipline is a necessary component of a successful investment experience. Given the random nature of market performance around the world, exercising discipline allows the benefits of time diversification to manifest itself. It is a big world out there and investors are best served by moving outside what is familiar and buying and holding a globally diversified portfolio of index funds. Because we do not reliably know which part of the world is going to be the next top performer, it is prudent to hold both domestic and foreign securities.