Global Diversification ..... why Bother!!!

I have written somewhat extensively with regards to the importance of portfolio diversification- though with the increasing outperformance of the US over the rest of the world over the last 15 years magnifying, there have been growing calls to abandon diversification altogether and stick with US stocks exclusively. Performance since coming out of the GFC (inception Feb 2011 with the inception of the VXUS ETF):

S&P 500 (299%)

ACWI Global stocks (of which US stocks constitute a little over a half: 204.2%

VXUS: Global ex US (82.7%)

Proponents of this way of thinking point to the fact that the largest fastest growing companies are located in the US, they have a higher exposure to the tech sector, a relatively stronger economy, strong currency etc etc.

And whilst that may be all well and true, the underlying rationale for diversification remains true at all times, irrespective of expectations for the future. A crystal ball that could accurately predict the future would be a compelling counter argument. But absent of which, diversification is the name of the game.

Diversification is frustrating, because it almost guarantees you that parts of your portfolio will be underperforming at any point in time.

Diversification is frustrating, because you are unlikely to be invested exclusively in the winners.

Diversification is frustrating, because with the benefit of hindsight, its possible your portfolio would have been fine without it.

Nonetheless, as with all aspects of investing, diversification is a trade off. Diversification is accepting that you will never make that “home run”, but at the same time, your long term financial goals will have a much higher chance of being met. You “owe it” to your future self.

The very nature of markets tends to be somewhat cyclical in nature, in the sense that for whatever reason the growth potential of a particular sector or segment of the market tends to be under appreciated, that segment goes through a period of strong returns, drawing in an increasing number of investors. Ultimately, the market saturates as it is unable to replicate the strong growth as expectations becomes excessively optimistic and the current price reflecting that unlikely future growth is unsustainable, and the market readjusts as expectations become more realistic. Rinse, wash and repeat.

Although clearly the US has had a massive outperformance over the last 15 years or so, that does not negate the need for global diversification. I have no doubt, that US dominance will end at some point. Will that be tomorrow? Next week? 17 years? 27th April 2057? Not a clue. But the risk of that outperformance ending at the most in-opportune time is too great to bear, and rationale investors will ensure they are appropriately diversified at all times. They will accept a lower, but more viable and sustainable return, than the more romantic but higher chance of blowing up more concentrated return.

We have been down this path before. Not that I am an old enough to remember the era, the 70’s and 1980’s was a great time for the Japanese investor. At the onset of the 1970’s, Japan was the 3rd largest economy. Even though the price of oil tripled in 1973, and cumulatively by more than 10x during the 70’s as a whole, Japan’s stock market more than trebled. Japan, despite it being entirely dependent upon imported oil, had very strong underlying fundamentals, whilst the majority of the Western World struggled. The Japanese stock market collectively compounded during the 1970’s at about 11% annually, whilst the S&P pretty much went nowhere.

Come the end of the 70’s, a Japanese investor had seen the market compound annually at about 11% each year. And then a further 19% annually for the next 10 years! See the performance of the Nikkei in White below. That’s a cumulative return of about 1,520% - not too shabby. The US investor by contrast saw a cumulative return of a mere 280% during the same time period. As denoted by the Orange line.

?Hindsight is 20/20. And we all know how the story unfolds. But the Japanese investor was surely thinking to himself exactly the same thoughts that we are beginning to hear from American investors. The economy is (relatively) sound, the stock market has massively outperformed just about every other market. Why should we diversify? Sound familiar? The risk of underperformance precisely at the wrong time is just too great to bear. It was true then, and it remains just as true today. As the graph showing the performance over the entire timeframe (1970 through to today) bears out:

Despite the massive 20 year outperformance through 1990, the Japanese market only trickled higher since then. Whereas the S&P has risen 11% annually over the entire 50+year time period. The purpose of this is not to pick upon Japan. But to point out the danger in complacency.

One can also see this play out in the relative weightings of the Global Equity Markets. Due to its relative outperformance, the Japanese market went from about 4% of Global Equity markets to over 40%; although the chart is a little dated, it now represents about a 6% weighting.

It is important to point out that the returns are in local currency, ie S&P 500 in USD and Nikkei in Japanese Yen. Clearly, currency effects between one’s home, or reference currency, and the currency in question will have to be taken into consideration. For example the Nikkei performance in USD terms will be very different due to the effects of the USD/Yen. Of course investor’s have the ability to hedge out the currency, either partially or fully, but that is the topic of a whole nother post.

Another important point to note is that investors in most countries have a very strong “home country bias”. Investors typically allocate a larger proportion of their assets to investments within their country. That may be due to familiarity, possible increased transaction costs in investing in overseas stocks, or exposure to FX risks. It is interesting that home bias remains as strong as it is, given the strong movement towards globalization, making markets far more interconnected than they ever were. But the fact remains that the phenomenon exists, and allows a relatively easy way to diversify one’s portfolio. It also protects against any systemic risk against one’s home country, ie provide protection in the risk that a downturn may exist almost exclusively in your home country. So because of the home country bias, there is always likely to be strong continuous inflows into local markets.?

There are several other interesting data points that comes out from the analysis. Note that the performance shown is through to the end of 2023, to allow for easier comparison on an annualized basis. Year to date, the S&P is up an additional 11.2%, the Nikkei 15.1%, the Dax 11.1%, the FTSE 6.7% and the CAC 6.3%.

Markets (as a whole) have been on an absolute tear! Particularly over the last 5 years. Which is quite unbelievable when one thinks of all the recent tumultuous events we are living through.

Clearly, whenever quoting performance, the story is very much what happens between the very specific starting and ending points chosen, but completely ignores what happens both preceding and following the timeline. That being said, when splitting up the performance since 1970 into decades (which is a reasonably long enough time frame), there are a number of interesting data points.

?Firstly, the performance is all over the place! There are very strong differences between different time frames, different countries, a couple of lost decades in there for fun.? It highlights the cyclicality of market returns, where good times do not last forever, but neither do bad times. To me, this highlights the difficulties in identifying winning markets over the long term, and calls for a continued global asset allocation at all times!

It is important to point out that the analysis provided has been performed on a Total Return Basis. That means that the return/performance is assuming that you have re-invested dividends received back into the index, allowing your earnings to compound and materially improve the performance of your holdings over time. Which leads me to a tangent ..... with the S&P dividend yield a paltry 1.33% ...... how much of a big deal is it if I choose not to reinvest the dividend, but to go and? use it for other purposes? Stay tuned to find out!