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%.”