Is there really no such thing as a free lunch?
If you were asked “Is diversification within your portfolio a good thing?” would you nod your head eagerly in agreement? If you were asked the important follow up question of “Why?”, what would come to mind? Diversification has become so common in investing that it is easy to take it for granted without taking the time to understanding why it so important to a successful long-term investment experience. Let’s explore the benefits of something that has been coined the “only free lunch in finance.”
When you diversify your portfolio, you are essentially distributing your capital across a variety of different securities so that you are not overly concentrated to one specific risk. Unnecessary over-concentration to any one stock or industry exposes you to more volatile outcomes. Let’s say you have a portfolio that is primarily composed of oil and gas stocks. It’s safe to say that these stocks would be highly correlated with each other, meaning that because they are subject to many of the same market and economic forces, they are likely to move in the same direction. If OPEC decided to oversupply the market, this would lower the global price of oil and your stocks may struggle as their profit margins compress. Remember though, there are two sides to every coin and other industries benefit from reduced oil and gas prices. An example would be transportation companies like FedEx and UPS, for whom oil and gas costs represent a significant portion of their operating expenses. If you have both of these industries plus others in your diversified portfolio, there can be an offsetting of returns effect which helps to lower the volatility of your portfolio without sacrificing expected returns.
Diversification goes beyond just sector. As an investor, you can diversify on many different levels including geographical exposure. Below is something we call the Quilt. At first glance, it can seem almost nausea inducing but it is really an elegant visualization of the importance of being globally diversified. Each country has a unique color and is ranked by the return of its local stock market index. Along the top row are the countries with the highest return in that year and along the bottom are the worst. Amongst the madness, does a pattern emerge for you? It’s not a trick question. The only take away from the Quilt is that the global returns of different stock markets are completely unpredictable. Which country is going to perform the best in 2020? Print this out and throw a dart at it: it’s as good a guess as any.
Source: Dimensional Fund Advisors
The investing climate is rife with shiny objects ready to steal you away from diversification should you cave to the temptation. Case in point, the returns of the S&P 500 over the last 10 years. From 2010 through 2019 the S&P 500 had a total return of 256% for an annualized return of approximately 13.5%. Not too shabby… How did a global index like the MSCI All Country Index fair over that same period? It had a total return of 62.4% for an annualized return of around 5%. That doesn’t seem to align with the theory that global diversification is a good thing, does it? Rather than rushing to put all your capital into the US market, it might help to look at the 10 years before that.
Equity Returns of Developed Markets (2000-2009)
Source: Returns presented in US Dollars. Dimensional Fund Advisors
Had you done the aforementioned and put all of your eggs in one basket, you would have lost money over a 10-year period which is widely referred to as the ‘lost decade.’ What are the next 10 years going to look like? Hopefully by now you know that nobody has a crystal ball. Is there a better way than rolling the dice on one country or printing out the Quilt of countries and throwing a dart at it? Of course, and give yourself a pat on the back because you’re doing it already. By holding Dimensional’s global portfolios you are the proportional owner of 1000s of stocks which vary across country, sector, and stock style. Doing this means that you are less likely to knock it out of the park in any given year because you were solely holding that one “hot” stock or market, but you’re also taking significantly less risk. Less risk for a given return means a higher probability of achieving your financial goals and isn’t that what a successful investment experience is all about?