Why Global Diversification Matters

By Anthony Davidow, vice president, alternative beta and asset allocation strategist, Schwab Center for Financial Research (emphasis by Madison)

Since the beginning of the bull market in 2009, U.S. stocks have outperformed international stocks, causing some investors to question the merits of global asset allocation. They wonder whether the risks abroad justify investing money outside the United States—and whether there truly are diversification benefits to doing so. Some have even challenged Modern Portfolio Theory, which emphasizes the long-term benefits of a diversified portfolio, itself.

In some ways it’s natural. It’s an unpredictable world, and investors worry about market volatility both at home and abroad. Everything from uncertainty about Brexit to worries about trade friction to concern about Federal Reserve rate hikes has indeed contributed to market swings.

Moreover, in investing—as in sports and other areas of life—people often exhibit familiarity bias (“home-country bias” in this case). We’re inclined to believe in and root for the things that we know best. While this may be human nature, home-country bias limits an investor’s universe of available opportunities. Worse, it may not be prudent given the nature of today’s global markets: According to MSCI data, roughly half of all global companies are based outside the United States, which corresponds to global gross domestic product ratios.

Do you really want to limit your investment opportunities by half? How can you overcome home-country bias?

Times like these show why the adage “don’t put all your eggs in one basket” is so vital for investors. An asset class that performs well one year might be a poor performer the next. For example, in 2017, emerging markets and international stocks were the top performing asset class (37.8% and 25.6% respectively)—but emerging markets is at the bottom so far in 2018, and international is near the bottom.

Over the long run, there’s no discernible pattern to the rotation among the top performers, so it doesn’t make much sense to concentrate all your investments in a particular region or asset class, or worse yet try to “time the market.” A globally diversified portfolio—one that puts its eggs in many baskets tends to be better positioned to weather large year-over-year market gyrations and provide a more stable set of returns over time.

Why consider a global allocation?

The short answer is that it’s almost impossible to avoid international exposure in today’s globally interconnected economy. Nearly half the revenues of the U.S. companies in the S&P 500® Index come from overseas. And more than half the world’s market capitalization now lies outside the United States.

Some might say that argues against global diversification, that because everything is so interconnected, overseas investments might simply overlap domestic ones. But that’s not the case: Companies tend to act in ways that reflect their “country of domicile.” They tend to respond to local economic and geo-political events more than events outside their borders. And different countries’ economies often tilt toward different market sectors or industries.

As the data above illustrates, there are potentially attractive investment opportunities outside of the U.S. While the U.S. markets have performed well recently, emerging markets and various countries have delivered strong results over time. Emerging markets was the best performing asset class in 2017, while the U.S. lagged many other countries. So far in 2018, we’ve seen a reversal, with the U.S. market dominating and emerging markets lagging. The point is: Rather than chasing the best performing markets, we believe that it is prudent to invest in multiple markets through a globally diversified portfolio.

If you don’t invest globally, you’re not only narrowing your opportunity set but ignoring an important tool to help manage volatility. Though not without risk, a global allocation provides diversification benefits and is one of the underpinnings of modern wealth management.

To illustrate the value of diversification, let’s compare the growth of $100,000 invested in three hypothetical portfolios prior to two extreme periods: the bursting of the tech bubble—which inflated in the late 1990s—and the Great Recession of 2007 to 2009. If an investor had held only U.S. large-cap stocks, as represented by the S&P 500®, that portfolio would be worth more than $313,000. Had they invested the same amount in a more conservative blend of 60% stocks and 40% bonds, they’re portfolio would have weathered the market storms a bit better, but would have trailed during the recent bull run ($283,793). But had they been globally diversified, with assets varied enough to temper market turbulence and positioned to take advantage of overseas opportunities, their $100,000 stake would have grown to $345,204.

Strategic asset allocation requires a long-term view, and it shouldn’t be unduly influenced by short-term considerations. This is an investment strategy for the long haul that requires patience and discipline. The right mix of assets for you and your goals should be based on your risk tolerance, cash flow needs, investing experience and time horizon, among other factors. And you should revisit your allocation periodically, if there is a change in your circumstances or whenever your goals or objectives change.

Important Note: This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. The opinions expressed herein are those of the named advisors at the time written.  Actual economic or market events may turn out differently than as presented. © 2018 Madison Wealth Management