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Avoid "diworsification" of your portfolio

Publication
Article
Medical Economics JournalMedical Economics May 2023
Volume 100
Issue 5

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.

Investing; Image credit: ©sergey_p - stock.adobe.com

Investing; Image credit: ©sergey_p - stock.adobe.com

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.

Routinely Recommended

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:

  • Except for a handful of years — primarily, the period of Great Recession, from 2007 into 2009 — U.S. stocks have outperformed internationals every year over the last three decades.
  • For the 10-year period ended October 31, 2022, returns in the U.S. market outpaced foreign countries by 100%, delivering twice the gains. During this period the U.S. market returned 222%, with the lowest drawdown, -24.81%. And no other country has come close; No. 2 was Ireland, with returns of 116.80% and a drawdown of -39.15%. How other countries’ markets did compared with the U.S. can be seen in the chart shown here.
  • Regarding returns over the last five years of that 10-year period, the U.S. has again been with winner, gaining nearly twice as much as the No. 2 country — Israel.

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.

Inherent Disadvantages

Further, international diversification:

  • Distracts attention and diverts capital from domestic investment for gains from the long-term upward arc of the U.S. market, the dashboard of the American economy—the most powerful investment engine on the planet.
  • Introduces needless, counterproductive complications, which increase opaque costs. Keeping things simple is Warren Buffett’s formula for success; he invests only in companies that he understands. Understanding foreign companies is all the more difficult. Buffett also holds onto stocks for decades — something that’s hard to do amid high foreign-market volatility, increased exposure over time to the risk of capricious regulation and wide swings in currency markets.
  • Exposes investors to the effects of inferior business climates. A big reason that American markets are the world’s most rewarding is that the U.S. is the best place to start and run a business. This is because the U.S. is a nation not of men, but of laws, with court systems designed to support fairness and fight fraud. The fair playing field of the U.S., and the resulting greater potential for amassing personal wealth, hold strong allure for the world’s best and brightest to come here to start businesses. Many founders of the nation’s most successful companies are emigrants or second-generation Americans, including Jeff Bezos, Elon Musk and other global household names. Among the biggest successes are tech companies, whose growth comes in the environment of creative destruction to which the American economy is so conducive. The American business climate has brought and now sustains the power plants of the global digital revolution, which is turning out to be history’s most impactful and drives not only shares of tech companies but also those of countless companies whose productivity and profitability are enhanced by technology.

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.

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