Why Global Diversification Matters | Charles Schwab

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Why Global Diversification Matters

June 29, 2017

Over the past few years, some investors have begun to question the merits of global asset allocation. They wonder whether the risks abroad justify investing money outside the United States—and whether there truly are diversification benefits to doing so. Some have even challenged Modern Portfolio Theory itself, which emphasizes the long-term benefits of a diversified portfolio.

In some ways it’s natural. It’s an unpredictable world, and investors worry about market volatility both at home and abroad. Everything from political questions in the wake of the U.K.’s “Brexit” vote last summer to the recent U.S. elections to anticipation of the Federal Reserve raising rates have indeed contributed to market swings.

Moreover, in investing—as in sports and other areas of life—people often exhibit familiarity bias (“home-country bias” in this case). We’re inclined to believe in and root for the things that we know best. While this may be human nature, home-country bias limits an investor’s universe of available opportunities. Worse, it may not be prudent given the nature of today’s global markets: According to MSCI data, roughly half of all global companies are based outside the United States, which corresponds to global gross domestic product (GDP) ratios.

Do you really want to limit your investment opportunities by half? How can you overcome home-country bias?

As the saying goes …

Times like these show why the adage “don’t put all your eggs in one basket” is so vital for investors. An investment sector that performs well one month or year might be a poor performer the next. For example, as the chart below shows, emerging market stocks were the top-performing asset class in 2007. Then they were the worst performer in 2008—only to rebound back to the top in 2009. More recently, small-cap stocks and high-yield bonds were the top performers in 2016, after placing near the bottom in 2015.

Over the long run, there’s no discernable pattern to the rotation among the top performers, so it doesn’t make much sense to concentrate all your investments in a particular region or asset class. A globally diversified portfolio—one that puts its eggs in many baskets, so to speak—is likely to be better positioned to weather large year-over-year market gyrations and provide a more stable set of returns over time.

How key asset classes compare to a diversified portfolio

The relative returns of individual asset classes vary widely from year to year.

Source: Morningstar Direct and the Schwab Center for Financial Research. Data is from January 1, 2006, to December 31, 2016. Asset class performance represented by annual total returns for the following indexes: S&P 500® Index (U.S. Lg Cap), Russell 2000® Index (U.S. Sm Cap), MSCI EAFE® net of taxes (Int’l Dev), MSCI Emerging Markets IndexSM (EM), S&P United States REIT Index and S&P Global Ex-U.S. REIT Index (REITs), S&P GSCI® (Commodities), Barclays U.S. Treasury Inflation-Protection Securities (TIPS) Index, Barclays U.S. Aggregate Bond Index (Core Bonds), Barclays U.S. VLI High Yield TR Index (High Yld Bonds), Barclays Global Aggregate Ex-USD TR Index (Int’l Dev Bonds), Barclays Emerging Markets USD Bond TR Index (EM Bonds), Barclays Short Treasury 1–3 Month Index (T-Bills).

The diversified portfolio is a hypothetical portfolio consisting of 18% S&P 500, 10% Russell 2000, 3% S&P U.S. REIT, 12% MSCI EAFE, 8%, MSCI EAFE Small Cap, 8% MSCI EM, 2% S&P Global Ex-U.S. REIT, 1% Barclays U.S. Treasury, 1% Barclays Agency, 6% Barclays Securitized, 2% Barclays U.S. Credit, 4% Barclays Global Agg Ex-USD, 9% Barclays VLI High Yield, 6% Barclays EM, 2% S&P GCSI Precious Metals, 1% S&P GSCI Energy, 1% S&P GSCI Industrial Metals, 1% S&P GSCI Agricultural, 5% Barclays U.S. Treasury 3¬–7 Yr. Including fees and expenses in the diversified portfolio would lower returns. The portfolio is rebalanced annually. Returns include reinvestment of dividends, interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Diversification strategies do not ensure a profit and do not protect against losses in declining markets. Past performance is not guarantee of future results.

Why consider a global allocation?

The short answer is that it’s almost impossible to avoid international exposure in today’s globally interlinked economy. Nearly half the revenues of the U.S. companies in the Standard & Poor’s 500® Index come from overseas. And more than half the world’s market capitalization now lies outside the United States.

Some might say that argues against global diversification, that everything is so interconnected, overseas investments might simply overlap domestic ones. But that’s not the case: Companies tend to act in ways that reflect their “country of domicile.” They tend to respond to local economic and geo-political events more than events outside their borders. And different countries’ economies often tilt toward different market sectors or industries.

In addition, certain circumstances—call them “new market realities”—are likely to persist for the foreseeable future. Increased globalization and interconnectivity, increased volatility, lower bond yields, and lower expected stock returns than in the past all suggest that it’s prudent for investors to branch out globally. Global diversification can help in managing risk and positioning your portfolio for long-term growth.

As the data below illustrates, there are attractive investment opportunities outside of the U.S. While the U.S. markets have performed well recently, the emerging markets and individual countries have delivered strong results over time. Canada was the top-performing market in 2016 and the bottom performer in 2015. Its results were largely impacted by energy prices. And of course various countries are at different stages of global and economic growth.

If you don’t invest globally, you’re not only narrowing your opportunity set but ignoring an important tool to help manage volatility. Though not without risk, a global allocation provides diversification benefits and is one of the underpinnings of modern wealth management.

Why diversify across borders?

The annual stock market returns in 11 regions from 2006 to 2016 shows the value of global diversification. Because when it comes to international investments, the results tend to be all over the map.

Source: Charles Schwab & Co., Inc., with data from FactSet, MSCI as of December 31, 2016. Geographical performance is represented by annual total returns for the following: MSCI AC World, MSCI USA, MSCI Japan, MSCI United Kingdom, MSCI Switzerland, MSCI Germany, MSCI France, MSCI Canada, MSCI Australia, MSCI Nordic Countries, MSCI Spain, MSCI EM (Emerging Markets). Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Diversification strategies do not ensure a profit and do not protect against losses in declining markets. Past performance is not guarantee of future results.

Why does diversification work?

A diversified portfolio owns a portion of many asset classes, so it can benefit from owning top performers without bearing the full effect of owning bottom performers. By avoiding the extreme peaks and valleys of each individual asset class, a diversified portfolio helps “smooth” returns over time, and will generally outperform a less-diversified portfolio over the long run.

Chart 3: A well-diversified portfolio can help lower volatility and improve returns over time.

To illustrate the value of diversification, let’s compare the growth of $100,000 invested in three hypothetical portfolios prior to two extreme periods: the bursting of the tech bubble in the late 1990s and the Great Recession of 2007–2009. If an investor had held only U.S. large-cap stocks, as represented by the S&P 500, their portfolio would be worth over $230,000. Had they invested the same amount in a more conservative blend of 60% stocks and 40% bonds, they’d have weathered the market storms a bit better, with their portfolio growing to over $233,000. But had they been globally diversified, with assets varied enough to temper market turbulence and positioned to take advantage of overseas opportunities, their $100,000 stake would have grown to $280,609.

The only “free lunch” in finance

Nobel Prize–winning economist Harry Markowitz, the father of Modern Portfolio Theory (MPT), was the first to demonstrate that a diversified portfolio can deliver improved performance and lessened risk relative to individual asset classes. This notion that you’d get something for nothing is nearly unheard of in economics. And it’s why Markowitz famously called diversification “the only ‘free lunch’ in finance.”

The key concept behind the “free lunch” is correlation—or rather, a lack of it. Typically, the performance of individual asset classes aren’t perfectly correlated. If asset values do not move up and down in perfect harmony, then a diversified portfolio will have less risk than the weighted average risk of its parts.

Unfortunately, as we’ve experienced increasing bouts of volatility around the globe, correlations have been rising over the last several years, testing the precepts of MPT. We live in a more complex world than when Markowitz wrote his seminal work, with an expanded number of asset classes and markets that are more interconnected than at any time in our history.

However, it’s important to understand that even during periods of market stress, when correlations tend to increase, diversification still provides benefits as long as assets don’t move in perfect lockstep. It’s also important to recognize that asset allocation strategies can be dynamic—both in choosing which asset classes to include and in making tactical adjustments to reflect changes in the market, the global economy and even your personal circumstances.

What a globally diversified portfolio looks like

Today, asset allocation has evolved beyond domestic stocks, bonds and cash to include global diversification across equities, fixed income and nontraditional investments.

  • Equities: Large caps, small caps and international, including emerging markets
  • Fixed income: Treasuries, corporate bonds, municipal bonds, international bonds, emerging market bonds, high yield bonds
  • Nontraditional investments: Commodities, real estate investment trusts (REITs) and others

Strategic asset allocation requires a long-term view, and it shouldn’t be unduly influenced by short-term considerations. This is an investment strategy for the long haul that requires patience and discipline. The right mix of assets for you and your goals should be based on your risk tolerance, cash flow needs, investing experience and time horizon, among other factors. And you should revisit your allocation periodically, if there is a change in your circumstances or whenever your goals or objectives change.


Important disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

High yield bonds and lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the interest amount payable is also impacted by variations in the inflation rate as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of either the original face amount at issuance or that face amount plus an adjustment for inflation.

Risks of REITs are similar to those associated with direct ownership of real estate, such as changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and credit worthiness of the issuer.

Commodity-related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions, regardless of the length of time shares are held. Investments in commodity-related products may subject the fund to significantly greater volatility than investments in traditional securities and involve substantial risks, including risk of loss of a significant portion of their principal value.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Index Definitions

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Barclays Emerging Markets USD Bond TR Index tracks the total return for debt instruments of the emerging markets.

Barclays Global Aggregate Ex-USD TR Index is designed to be a broad-based measure of global investment-grade fixed income markets outside of the U.S.

Barclays U.S. Agency Index includes native currency agency debentures from issuers such as Fannie Mae, Freddie Mac, and Federal Home Loan Bank. It is a subcomponent of the Government-Related Index (which also includes non-native currency agency bonds, sovereigns, supranationals, and local authority debt) and the U.S. Government Index (which also includes callable and non-callable agency securities that are publicly issued by U.S. government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. government (such as USAID securities). The U.S. Agency Index is a component of the U.S. Aggregate Index and the U.S. Universal Index.

Barclays U.S. Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of one year or more.

Barclays U.S. Credit Index tracks all investment-grade corporate and U.S. government issues over $200 million with remaining maturities of between one and ten years.

Barclays US Securitized Bonds Index is a composite of asset-backed securities, collateralized mortgage-backed securities (ERISA-eligible) and fixed-rate mortgage-backed securities.

Barclays U.S. VLI High-Yield TR Index includes publicly issued USD-denominated, non-investment-grade, fixed-rate, taxable corporate bonds that have a remaining maturity of at least one year and have $600 million or more outstanding face value.

Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index is a market-value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).

Barclays Short Treasury 1-3 Month Index includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of more than one month and less than 3 months. Included securities are investment-grade, have $250 million or more of outstanding face value, denominated in U.S. dollars, fixed rate, and non-convertible.

MSCI AC World—Total Return Index is a free float‐adjusted market-capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 46 country indexes comprising 23 developed and 23 emerging market country indexes. The developed market country indexes included are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States. The emerging market country indexes included are Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey* and the United Arab Emirates.

MSCI Australia—Total Return Index is designed to measure the performance of the large- and mid-cap segments of the Australia market. With 72 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Australia.

MSCI Canada—Total Return Index is designed to measure the performance of the large- and mid-cap segments of the Canadian market. With 94 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Canada.

MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index designed to measure the equity market performance of developed markets, excluding the U.S. & and Canada. It consists of 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

MSCI EAFE Small Cap Index is an equity index which captures small-cap representation across developed market countries around the world, excluding the U.S. and Canada.

MSCI EM (Emerging Markets)—Total Return Index is a free float‐adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey* and United Arab Emirates.

MSCI France—Total Return Index is designed to measure the performance of the large- and mid-cap segments of the French market. With 74 constituents, the index covers about 85% of the equity universe in France.

MSCI Germany—Total Return Index is designed to measure the performance of the large- and mid-cap segments of the German market. With 55 constituents, the index covers about 85% of the equity universe in Germany.

MSCI Japan—Total Return Index is designed to measure the performance of the large- and mid-cap segments of the Japanese market. With 318 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan.

MSCI Nordic Countries—Total Return Index captures large and mid-cap representation across 4 Developed Markets (DM) countries*. With 66 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

MSCI Spain—Total Return Index is designed to measure the performance of the large and mid-cap segments of the Spanish market. With 25 constituents, the index covers about 85% of the equity universe in Spain.

MSCI Switzerland—Total Return Index is designed to measure the performance of the large- and mid-cap segments of the Swiss market. With 40 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Switzerland.

MSCI U.S. REIT Index is a free float-adjusted market-capitalization-weighted index that is comprised of equity REITs that are included in the MSCI U.S. Investable Market 2500 Index, with the exception of specialty equity REITs that do not generate a majority of their revenue and income from real estate rental and leasing operations. The index represents approximately 85% of the U.S. REIT universe.

MSCI United Kingdom—Total Return Index is designed to measure the performance of the large- and mid-cap segments of the U.K. market. With 113 constituents, the index covers approximately 85% of the free float- adjusted market capitalization in the U.K.

MSCI USA—Total Return Index is designed to measure the performance of the large- and mid-cap segments of the U.S. market. With 633 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the U.S.

Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set.

S&P 500® Index is a capitalization-weighted index of 500 stocks from a broad range of industries. The component stocks are weighted according to the total market value of their outstanding shares.

S&P Global REIT ex-U.S. Index measures the investable global real estate investment trust market and maintains a constituency that reflects the market’s overall composition.

S&P United States REIT Index measures the investable U.S. real estate investment trust market and maintains a constituency that reflects the market’s overall composition.

S&P GSCI®(Goldman Sachs Commodity Index) is a world production-weighted index comprised of the principal physical commodities that are the subject of active, liquid futures markets. 

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