Swedroe: Diversify Globally To Limit Risk

Diversification is often referred to as the only “free lunch” in investing because, when done properly, it allows investors to improve risk-adjusted returns. This principle applies not just to diversification across U.S. stocks, but to investing globally. The choice to purchase securities internationally helps mitigate the economic and political risks of investing in only a single country.

The Credit Suisse Global Investment Returns Yearbook 2015 provides us with another good reason for globally diversifying portfolios. It contains an article written by Elroy Dimson, Paul Marsh and Mike Staunton, titled “Industries: Their Rise and Fall.”

In it, the authors explain that “mankind has enjoyed a wave of transformative innovation dating from the Industrial Revolution, continuing through the golden age of invention of the late 19th century, and extending into today’s information revolution.” They go on to show “how industries have risen and fallen as technology has advanced.”

Diversify Across Industries …

The authors acknowledge that even though “successive waves of new industries and companies have transformed the world,” they have “sometimes proved disappointing investments.” The reason is that “new industries can deliver disappointing returns if stock market prices are initially too optimistic about future growth.”

Sometimes the older, more established industries provide high returns as prices become “too depressed.” The stocks in these industries often belong to value companies, and there has been a persistent value premium around the globe.

According to the authors, “industries perform very differently from one another, even if it is hard to predict these differences in advance. Industries and industry weightings matter.”

Their recommendation is that investors “shun neither new nor old industries.” The authors believe building a well-diversified portfolio requires that investors become well-diversified by industry. To do that, investors have to diversify globally. Global diversification matters because industries are highly concentrated within countries.

In 35 of the 40 industries the authors covered in their study, “the two countries with the largest weights account for over half the industry’s global capitalization; in 30 industries, the top two countries account for more than 60% of industry weight; in 18 industries, they account for over 70%; and in seven industries, for over 80%.”

… By Investing Globally

And “just as industries can be concentrated within a few countries, so countries can be dominated by a handful of industries.” For example, “the weighting of the three largest industries accounts for at least 40% of country capitalization for 42 out of the 47 countries; for at least 50% for 33 countries; for at least 60% for 21 countries; and for 70% or more in 15 countries.”

The authors conclude: “The implications are clear. Investors in most countries will have poorly diversified portfolios, with heavy industry concentration if they restrict investment to their own country. This reinforces the imperative to diversify internationally. But many industries are concentrated within particular countries. This underlines the need for global diversification across countries in order to diversify effectively across industries.”

The U.S. is among the countries least concentrated by industry, but we still have “a heavy weighting in technology (17%), high weightings in oil and gas, health care and consumer services, and lower weightings in basic materials, consumer goods and telecoms.” On the other hand, the U.K. has “a tiny weighting in technology (1%), but a high weighting in resources (over 25% in oil and gas plus mining stocks within basic materials) and financials (22%).”

Another example is that emerging markets have “a high weighting in financials (32%, of which two thirds is in banks), and are overweight the world index in oil and gas and basic materials. These three sectors make up almost half of emerging market capitalization. Emerging markets are also overweight in telecoms, very underweight in health care, and underweight in consumer goods and services.”      

The implication of the authors’ research for investors is that, while “industry” isn’t a priced factor like beta, size and value, it remains an important investment factor. Because the stock markets of many countries are relatively highly concentrated within a few industries, and many industries are concentrated within a few countries, to exploit diversification opportunities to their fullest, investors need to diversify across a wide spread of industries and countries.

Beware Of Home-Country Bias

Finally, the authors noted: “There is evidence that globalization has led to a decline in the relative importance of countries, with industries assuming greater importance.”

Based on my own 20 years of experience as a financial advisor, I would add the following words of caution. One of the most common mistakes made by investors from all over the globe is a strong tendency toward home-country bias. I believe this results from what I refer to as confusing the familiar with the safe. This bias leads investors to believe that their home country is not only the safest place to invest, but that it will produce above-average returns.

This assumption defies one of the most basic principles of finance: that risk and expected return are related. Predictably, the result is a failure to globally diversify. That can prove very costly because we don’t actually live in Lake Wobegon, where all countries are somehow both the safest place to invest for their residents and also provide the highest returns.

If you doubt the wisdom of global diversification, consider the case of Japan—understand that the same thing could happen here. From 1970 through 1989, Japanese stocks far outperformed U.S. stocks. The MSCI Japan Large Cap Index returned 22.4 percent, 10.9 percentage points a year higher than the return of the S&P 500 Index.

Unfortunately, over the next 25 years, the S&P 500 returned 9.6 percent per year while the MSCI Japanese Large Cap Index fell 0.8 percent a year, an underperformance of 10.4 percentage points per year. In 1989, there was a lot of focus on how the Japanese economy was taking over the world, even gobbling up prime U.S. real estate (like Rockefeller Center and Pebble Beach Golf Course).

But I’m not aware of anyone who predicted what actually happened. And I’m sure it caught Japanese investors by surprise. The bottom line is that failing to diversify globally means inviting a lot of unneeded risk.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.