Why Should You Diversify : March 2016
“Things are so uncertain in Europe and other places around the world” a client commented to me during our meeting. “Should I really be invested outside the U.S. right now?” It’s a great question, and one I’ve heard a lot. We are confronted with issues outside the U.S. that could very well lead to more market volatility: Great Britain’s upcoming vote on whether to leave the EU (Brexit), the uncertain political situation in the Middle East, and China’s slowing growth to name a few. Nevertheless, an emphatic “yes” was my answer.
This answer is often counterintuitive to investors, but it is worthy of exploration because it touches on an important concept in investing: the power of a diversified portfolio. While individual securities are more likely to fluctuate, the fact that the investor holds securities from such a wide sample of economic and political environments can provide greater stability to the portfolio as a whole. Moreover, it is not the risk and return characteristics of a single security (or this case country) that is important, but rather the contribution that the security (or country) makes to the risk and return characteristics of the overall portfolio. To help understand why, here is a video from Vanguard that describes the benefits of investing globally vs. solely in the U.S. It illustrates how non-U.S. stocks have given investors a bumpier ride than U.S. stocks, but a globally diversified portfolio has bounced around less than both.
For those unfamiliar with the benefits of diversification, we can think of the farmer who wants to ensure a reliable harvest in spite of mother nature’s unpredictability. In addition to slow and reliable crops that are known to do well during standard weather conditions, a farmer may choose to devote land to two or three crops that are less “native” to the region. Choosing crops that thrive in different weather patterns (one favored by dry conditions, another by wet, for example) allows the farmer to know that a year of extreme weather is less likely to wipe out his entire harvest. While a globally diversified portfolio will not guarantee against losing money, like the farmer who plants different crops, you may experience a lower degree of volatility by broadening your exposure to different countries with their own unique risks and opportunities.
For further reading, here is an article from Dimensional Fund Advisors entitled “Why Should You Diversify?” It goes deeper into the topic of global diversification, and specifically discusses why the underperformance of non-U.S. stocks over the past few years should not be cause for investors to reevaluate the benefits of investing outside the U.S.
As always, please feel free to contact Gabor or me if you have questions or comments.