This Is Why Investment Diversification Is Important

Of all the factors involved in building your portfolio, investment diversification is, arguably, the most important

There is a lot of wrong information in the blogosphere and financial media about how to invest. It's hard to know what to believe. There's the simplistic view of many bloggers who advocate the three-fund Vanguard portfolio. Popularized by the Bogleheads movement, the three-fund portfolio is one of the more popular styles promoted by the DIY community.

Then we have the market timers. These folks say they have a formula to time the buying and selling of securities to get the highest returns. There's high-frequency trading, alternatives, direct investments, and hedge funds. The list seems endless.

In this post, we'll do a surface review of some of the strategies. I'll spend most of my time talking about the importance of investment diversification in achieving long-term success.

We won't talk much about bonds in this discussion. I wrote about the importance of bonds in another article. For this discussion, we will focus on world stock markets.

Why Investment Diversification Is Important

Start with a Plan

If you have followed my writing for any time at all, you know I believe that everything begins with a plan. Whether you develop that plan on your own or use a financial advisor, the best way to have success is with a plan.

I've written about knowing your “why” and the importance of making sure your values align with your money. Everything starts there.

Why? It's simple.

If you have long-term goals, tied to a time frame for achieving them, and a plan to get there, you will have a better chance of being successful in hitting your goals. Having a plan helps you through the challenging times, be that market related, or with the changing circumstances of life. Staying focused on our goals helps us persevere. Without them, we are more likely to shift from one big idea to another big idea chasing the elusive returns we hear about in the media or from our neighbors.

A goal without a purpose will be harder to accomplish. Maybe you have a long-term goal to achieve a certain amount of wealth. Maybe that's tied to accumulating $2 million by age 55. That sounds like a great goal on the surface. Here's the $2 million question – why do you need that amount of money? How did you arrive at that number? Why is it important to you? If you can't answer those questions, it will be easy to stray from the goal.

The Purpose

If, however, there is a purpose behind that goal aligned with your values, you'll find it easier to stay focused.

Let's say the reason you came up with that dollar amount was to fund a particular lifestyle in retirement. You know where you want to live, have settled on what you want to be doing, and on how you will spend your time. You've calculated what other sources of income you'll have (Social Security, pensions, inheritances, etc.) and determined that the $2 million is what you need to fund the desired lifestyle.

The $2 million number is your number. It isn't some arbitrary number advocated by a fund company, blogger, or other pundits who have no clue about your situation. It's a number you came up with on your own or with the help of a professional. You know how much you have to save and what return you need to get to that number. You've also calculated the risk you need and are willing to take to achieve your goal.

To me, that has to be the foundation.

Ways to Invest

Beating the Market

Wall Street and much of the mutual fund industry would have us measure our investments against the market. There are several problems with this approach. Here are my top two.

  1. Who cares?!?! – I'm serious. Whether we beat the market, our next-door neighbor, our coworker, or any other arbitrary measure of return is immaterial to us. The performance that should matter to us is that which gets us to our goals – OUR LONG-TERM goals. Short-term market ups and downs are not important. If our time frame is ten, twenty, thirty years out, those are the returns that matter.
  2. Which market? – The world stock market has roughly 52% in the U.S., 36% in foreign developed markets, and 12% in emerging markets. Which one of those are we trying to beat? How much do we have invested in each of these? (refer back to #1) When we hear about someone getting X return, and we're getting 15% less than X, does that matter? No. First of all, we don't know how the investments they have compared to what we own. It's likely an apple to oranges comparison.

Many of us are so competitive and may suffer from FOMO (Fear of Missing Out) that we end up chasing returns to keep up with what others say they're getting. Here's the problem. There will always be someone who gets better performance than you. Who cares?

Active Fund Management

One aspect of active fund management is the age-old theory that says fund managers can look at the technical data (trends) of the market and individual stocks and determine the right time to buy or sell. They might also tout their fundamental analysis of the companies they buy trying to convince us this analysis will offer outperformance over their respective index.

Oh really?

Why is it that the longer the period, the less likely a fund will outperform its benchmark (a benchmark is an unmanaged index chosen by the fund against which to measure their fund performance).

The following chart shows the percentage of U.S. equity funds outperformed by their benchmarks.

image of a chart showing % of funds underperforming benchmark

Remember, these fund managers use a combination of stock picking and timing to buy and sell stocks they think will outperform others. Collectively, the goal is to exceed their benchmarks. The chart does not explicitly measure market timing strategies only. It encompasses all fund strategies.

Actively managed funds have fees that are substantially higher than index or passively managed funds, which begs the question. Why would anyone want to pay additional charges for funds that underperform their benchmarks?

I can't think of a reason, can you? Passively managed and index funds are much less expensive and offer better returns than most funds (as the data suggest).

Individual Stock Picking

With this strategy, investors choose individual companies' stocks to put into their portfolios. Most of the time, investors adopt the buy and hold strategy. They buy stocks they believe will do well over the long-term. They don't pay management fees or fund expenses. The only fees paid are commissions to buy and sell the stocks.

The DIY portfolios I've seen over the years are full of the largest companies in the market. They are mostly U.S. companies. Information is much easier to get on U.S. companies, particularly the larger ones. Most of these portfolios mirror the S & P 500 stock index. They lack the smaller and medium-sized companies, which may offer higher expected returns.

Individual stock portfolios often don't have much international exposure. They invest mostly in the U.S. DIY investors often use ETFs to gain foreign market exposure. Since they trade like individual stocks, ETFs work well with this style of investing.

These brief descriptions of investing methods are not comprehensive. They combine two of the most common methods used by the average investor -actively managed mutual funds and individual stock picking. Inherent in the active fund strategy is market timing and fundamental analysis of the companies.

We did not cover day-trading, high-frequency-trading, alternative investments, cryptocurrencies, and many other types of investments. Though there are exceptions, most investors don't use these types of investments.

Investment Principles

These are the investment principals I believe should matter.

Markets Are Efficient

Over long periods, the stock and bond markets have provided investors with growth on their capital that exceeds that of inflation.

The efficient market hypothesis came from the research of Nobel Laureate Eugene Fama. It states that the prices of securities in the market at any given point in time reflect all of the information available. Thus, the current price represents a fair price. The idea is that the collective wisdom of the market is greater than any individual or group of individuals. That's the foundational principle of efficient markets and the underpinning of an evidence-based investment strategy.

If we believe the markets are efficient, there is no need to try to pick stocks that outperform. Anomalies exist, but they are impossible to identify consistently. Many will vehemently argue this point. The data from the chart above provide some pretty compelling evidence it's true.

Diversification

Investment Diversification Defined

Investment diversification means you don't want to have all your investment eggs in one basket. Having your investments spread across various asset classes (stocks, bonds, cash, real estate, etc.) helps manage risk.

In the 2008 financial crisis, lots of investors thought they had portfolio diversification until the world markets crashed. Whether you invested in the United States, developed international markets, or emerging markets, all investments dropped pretty dramatically. Diversification won't stop your portfolio from dropping. That's not the point.

Investment diversification reduces the risk of owning one asset class. Unlike the 2008 financial crisis, in most cases, investments do different things at different times. They don't all go up or down at the same time by the same percentages. And remember, you only lose money if you sell those investments during the market drops.

Diversification reduces risks. A broadly diversified global portfolio exposes investors to markets around the world and diversifies risks that have no expected return. If we want an entirely market-based globally diversified portfolio, it should include allocations in the world's markets. On average, world markets consist of 52% U.S, 36% foreign developed, and 12% in emerging markets. Most of us would not be comfortable having that much money in international stocks.

We might have 70% in the U.S. and 30% in foreign stocks, a small percentage of which would be emerging markets.

What You Can Control

Have an investment plan that fits your willingness, ability, and need to take risks. Keep trading costs and expenses low, minimize taxes, and have the discipline to stick to your plan.

If we accept these three principles, how do we invest? The short answer – index or other passively managed funds. Point #3 above emphasizes the need to focus on the things we can control. One of them is cost.

Actively managed funds have much higher costs than index funds. According to this article from Balance, active funds average expenses are over 1% I've seen expense numbers between 0.60% and 0.75%.

Index and passively managed funds are among the lowest cost funds available. The average index fund has fund expenses of less than 0.20%, with some less than 0.10%. That's a cost-saving that goes straight to your pocket.

Controlling management fees, trading costs, and expenses can increase returns.

Domestic Stocks

Passive funds' offer investors the opportunity to own every individual security in the index. The most common index is the S & P 500 index. The index includes the largest 500 companies by market capitalization. When we hear talk about the “market,” it is often referring to this index.

A much broader U.S. market index is the Russel 3000, which includes the largest 3000 U.S. companies. An even more comprehensive index is the Wilshire 5000, made up of the largest 5000 U.S. companies. When I look at investing in the U.S. market, I like the Russell 3000 as the benchmark. With over 3000 companies, it is more representative of the U.S. stock market.

The Russell 3000 consists of roughly 69% large companies, 21% mid-sized companies, and 9% smaller companies. Owning a fund that replicates the Russell 3000 offers exposure to the broader U.S. Stock market. A couple of fund examples in this category are iShares Core S & P Total Stock (ITOT) and  Vanguard Total Stock Market Index (VTSAX).

International Stocks

Since the world markets have around 36% in international developed markets, to properly diversify, portfolios should include foreign stocks. Like in the U.S., this is best accomplished via index funds. A total international fund like the Vanguard Total International Index (VTIAX) is an option. Be careful about choosing this fund. What many investors don't realize is that VTIAX has 20.50% (as of 10/31/2018) in emerging markets. Emerging markets make up roughly 12% of the world's stock market.

If VTIAX or another international alternative fund makes up 30% of your stock portfolio, that means you own just over 6% in emerging markets stocks. There's nothing wrong with that number in and of itself. When I've asked some who hold this fund, they had no idea how much emerging markets they owned. It's important to understand that emerging markets are one of the most volatile of the world stock indexes. In the 2007 – 2009 financial crisis, they dropped close to 60%.

Another way to manage exposure to emerging markets is to invest in a developed markets fund like the Vanguard Developed Markets Fund (VTMGX) and a separate emerging markets fund like the Vanguard Emerging Markets ETF (VWO). Doing this gives you control over how much you invest in developed vs. emerging markets.

Another choice in developed markets is iShares Core International Developed Markets (IDEV), and emerging markets consider iShares Emerging Markets (EEM).

Charles Schwab and Co. is also a place to look for low cost, no-fee ETFs.

The U.S. vs. International

Many newer investors have the bulk of their money in the U. S. market. That's served them quite well over the last several years.

For the five years ending October 31, 2018, the S & P 500 had an annualized return of 11.4%. During the same period, the MSCI World ex USA Index returned 1.86% while the MSCI Emerging Markets index returned 0.78%. Those who invested heavily in U.S stocks have substantially outperformed those with international exposures during that period.

It hasn't always been that way. Do you remember the “lost decade” for U.S. stocks? Younger investors may not. For those who've been around for a while, it's hard to forget. During the ten years from 2000 -2009, the S & P 500 index lost a cumulative -9.1%. That included the period from 2000-2002, where the index lost over 50% and the 2007-early 2009 period, where it lost close to 40%. Those invested heavily in the U.S. had a very different experience than those currently invested that way.

What's my point? Diversification matters. The chart below shows the returns of markets around the world during the lost decade for U.S. stocks. Take a look.

Chart of world market returns from 2000-2009

S&P data © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. MSCI data © MSCI 2018, 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.

During that same lost decade, foreign markets substantially outperformed their U. S. counterparts. A portfolio heavily weighted U.S. stocks during this lost decade would have significantly underperformed virtually any international market.

Final Thoughts

If you own a broadly diversified portfolio of stocks around the globe, you're probably not very happy with your results over the last few years. Your investments have, frankly, stunk compared to the soaring U.S. market.

If you're investing with a plan to reach specific goals, my advice is to stay the course. Other than to rebalance, the worst time to make a change is in a falling stock market.

Don't get caught up in comparing your results to your neighbor or coworker. Don't focus on what's happening this month, quarter, year, or even the last five years. Look at the long-term history and remember the lost decade for U.S. stocks. A well-diversified portfolio that included international stocks substantially outperformed the U.S. during that lost decade. The past few years, the tables have turned.

If you're investing regularly in a 401(k) or other employer retirement plan, keep putting in money. You're averaging out the price you're paying for your investments. You're reducing the risk of your investments and improving your chances of success.

If markets drop dramatically, it's an excellent opportunity to rebalance. Buy more of what's declined in value. Sell what is up in value. That's the incremental way to buy low and sell high.

Review your plan and your investments at least annually. Keep your head down. Focus on your goals and the plan to reach them. Ignore the noise, be it from media, your neighbors, coworkers, or wherever.

I hope you see from the evidence presented here that it works. Global investment diversification is a winning strategy.

Now it's your turn. Does this make sense? Are you globally diversified? If so, do you plan to stay with it? If not, have you considered adding more international stocks? I welcome your thoughts. 

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