A slavish devotion to diversification can be self-defeating.
Any investor not living in a barn has probably heard that portfolio diversification is a good idea.
The concept of holding a wide variety of investments to reduce risk and thus increase long-term net returns has been endorsed for decades by financial planners, consumer financial websites and financial media.
The staying power of this classic refrain makes the importance of diversification seem like a real no-brainer, like wearing seat belts or avoiding fatty foods.
Yet, while varying the types of investments in a portfolio to some extent might generally make sense in some cases, a slavish devotion to diversification can be self-defeating.
Among the routine recommendations of most financial planners for individual investors is to diversify internationally by buying stocks in foreign markets — usually through funds. Yet, if you look closely enough, you might see some fine cracks in the universality of this recommendation, evidenced by some almost grudging acknowledgments. Notably, while clinging to its classic recommendation to invest globally, Morningstar, the huge fund-assessment company, has conceded that the benefits can be “surprisingly elusive.”
Underlying these cracks is substantive tectonic pressure that, for at least the last several decades, has run counter to the advisability of diversifying stock portfolios internationally. So conclusive is this evidence that a more accurate term would be “diworsification” because this practice demonstrably increases risk and can erode returns.
Even regarding attempts to benefit from potentially alternating outperformance cycles, the U.S. market is so historically dominant in returns and so comparatively low in relative risk as to render consideration of diversifying globally moot.
Not Even Close
Concerning the performance records of equity indexes in the U.S. versus the Rest of the World, there’s no comparison:
For every period, the U.S. market has had the lowest volatility and the lowest drawdown among the world’s 25 leading national markets.
Proponents of global diversification stress that it’s an extremely long-term strategy. Yet long periods of American outperformance, sustained by huge foreign investment in the U.S., mean that U.S. investors would have had to start investing when they were too young to have much, if any, capital.
And even then, the odds would have been against them because correlations between foreign and U.S. markets have been growing, meaning that prices have shown an increasing tendency to rise and fall more or less together as sovereign economies have become more interconnected. This interconnection stems from increases in cross-border investment, the growth of global investment funds, increased American manufacturing outsourced abroad, and the longer, deeper consumer reach of multinational companies based in the U.S.
Along with inferior returns, Americans investing internationally are burdened by the albatross of currency risk, which can whittle away at realized returns; it can be prohibitively expensive to bring foreign returns home in spendable U.S. dollars.
Also, foreign investment brings more regulation risk, which can have severe consequences that are extremely unlikely to occur in free-market democracies such as ours. By fiat, the Chinese government (actually, the CPC — the Communist Party of China, as distinguished from what we think of as an actual government) in recent years has arbitrarily come down hard on groups of companies (usually tech) overnight, dunning their share values. The due process that we’re accustomed to in the U.S. is literally a foreign concept in China.
Further, international diversification:
All of this may sound like a lot of flag-waving and mom-and-apple-pie boosterism, but these are undeniable truths based on abundant evidence.
So, the next time you’re tempted to invest abroad, perhaps after hearing that the market in a given nation has become promising, consider the slim-to-none odds, based on market history, that its indexes will outperform those of the U.S.
Dave Sheaff Gilreath, CFP®, is a 40-year veteran of the financial services industry. He is a partner and chief investment officer of Sheaff Brock Investment Advisors, LLC, a portfolio management firm for individual investors, and Innovative Portfolios, LLC, an institutional money management firm. Based in Indianapolis, the firms manage about $1.3 billion in assets nationwide.