If you’ve been with us long enough, you know that we value efficient diversification on a very large scale. True diversification decreases your risk without decreasing your expected return over long periods of time; an invaluable component of a robust financial plan. Not only do we invest in thousands of different securities, but we also invest across the globe. But how and why do we choose to do so? Traditionally, investment managers would match how much they invest in each country with how large that country’s investment “footprint” was, making investments proportional to the market capitalization of each country. Another strategy has been to attempt to predict which countries will do well or poorly and invest accordingly. We know the latter doesn’t work, so is the former the ideal approach? Not for us. We prefer a more pragmatic approach and the result is an intentional “home-bias.” We invest more heavily in the US than in non-US securities. Why? Non-US markets are not perfectly correlated to US markets and they provide access to industries and companies that you otherwise would not be investing in. All of these factors provide a significant diversification benefit. However, investing in foreign marketplaces is more costly than investing in domestic markets and bears additional risks. Typically, there are larger bid-ask spreads, more market impact from trading, higher management fees, political risks, and currency fluctuations that all serve to negatively influence risk and return. The goal therefore is to maximize the diversification benefits at minimal cost.
Figure 1 (Above), shows the percentage of equity allocated to non-US Stocks compared to the change in volatility (as measured by standard deviation). Essentially, this shows what percentage of stocks historically needed to be allocated to non-US markets to achieve the maximum diversification benefit, based on historical data. As with any backwards looking analysis we must recognize that the past does not predict the future. Models of past data span several generations and may not be indicative of the optimal mix moving forward, especially when one considers that each portfolio is constructed with different constraints. What we can see, however, is that you can achieve optimal diversification without taking on unnecessary risks or costs. Historically, an investor would only need around 30% of their stocks in non-US markets to gain maximum benefit; much less than the actual market weight of non-US markets. Keep in mind, however, that you still want a healthy exposure to non-US markets to fully capture the benefits.
Figure 2 (Above), shows the non-correlated nature of US and non-US stocks. Recently, non-US markets have performed poorly causing many less-disciplined investors to discredit their benefit. We often hear that “the markets” are doing great and then our portfolio is only doing “okay.” The reason is because “the markets” usually only refers to a small portion of the US equity market, either the S&P 500 or the DOW. Only investors who concentrated solely in the S&P 500 or DOW would have returns close to the commonly cited “market;” not an advisable position for long term investors who understand pragmatic investing. I fully expect a well-diversified equity portfolio to outperform the S&P 500 over my investing lifetime, despite periods of underperformance. In the past several years, I’ve been able to review portfolios from other investment management firms. There are two common trends; they either avoid non-US Markets, or they match market capitalization. Neither of these strategies is ideal and indicate either a lack of proper diversification, discipline, or direction. At Financial Plan, we understand that costs and risk matter. We want to gain the maximum diversification benefit in the most efficient manner possible. We can rely on academics and pragmatic investing to achieve it. The benefit to our clients is an overall reduction in costs and risks in a practical manner, which does correlate to higher expected future returns.