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Why Global Diversification Matters

Why Global Diversification Matters

Since the beginning of the bull market in 2009, U.S. stocks have outperformed international stocks, causing some investors 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, which emphasizes the long-term benefits of a diversified portfolio, itself.

In some ways it’s natural. It’s an unpredictable world, and investors worry about market volatility both at home and abroad. Everything from uncertainty about Brexit to worries about trade friction to concern about Federal Reserve rate hikes has 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 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 asset class that performs well one year might be a poor performer the next. For example, as the chart below shows, emerging market and international stocks were the top performing asset class in 2017 (37.8% and 25.6% respectively)—but emerging markets is at the bottom so far in 2018, and international is near the bottom.

Over the long run, there’s no discernible 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, or worse yet try to "time the market." A globally diversified portfolio—one that puts its eggs in many baskets tends 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

Source: Morningstar Direct and the Schwab Center for Financial Research. Data is from January 1, 2008, to September 30, 2018. *2018 data is from January 1 to September 30, 2018. 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), Bloomberg Barclays U.S. Treasury Inflation-Protection Securities (TIPS) Index, Bloomberg Barclays U.S. Aggregate Bond Index (Core Bonds), Bloomberg Barclays U.S. VLI High Yield TR Index (High Yld Bonds), Bloomberg Barclays Global Aggregate Ex-USD TR Index (Int’l Dev Bonds), Bloomberg Barclays Emerging Markets USD Bond TR Index (EM Bonds), Bloomberg 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% Bloomberg Barclays U.S. Treasury, 1% Bloomberg Barclays Agency, 6% Bloomberg Barclays Securitized, 2% Bloomberg Barclays U.S. Credit, 4% Bloomberg Barclays Global Agg Ex-USD, 9% Bloomberg Barclays VLI High Yield, 6% Bloomberg 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% Bloomberg 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. Past performance is no indication of future results Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Why consider a global allocation?

The short answer is that it’s almost impossible to avoid international exposure in today’s globally interconnected economy. Nearly half the revenues of the U.S. companies in the S&P 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 because 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, we believe that there are certain “new market realities” that 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 potentially attractive investment opportunities outside of the U.S. While the U.S. markets have performed well recently, emerging markets and various countries have delivered strong results over time. Emerging markets was the best performing asset class in 2017, while the U.S. lagged many other countries. So far in 2018, we’ve seen a reversal, with the U.S. market dominating and emerging markets lagging. The point is: Rather than chasing the best performing markets, we believe that it is prudent to invest in multiple markets through a globally diversified portfolio.   

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?

2018 asset class performance

Source: Charles Schwab & Co., Inc., with data from FactSet, MSCI as of September 30, 2018. 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. Past performance is not guarantee of future results. Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

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 can help manage volatility over time, and may outperform a concentrated portfolio over the long run.

How diversification works

How diversification works

Source: Morningstar Direct and the Schwab Center for Financial Research. Data is from January 1, 2001, to September 30, 2018.

The 60/40 portfolio is a hypothetical portfolio consisting of 60% S&P 500® Index Stocks and 40% Bloomberg Barclays U.S. Aggregate Bond Index bonds. 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% Bloomberg Barclays U.S. Treasury, 1% Bloomberg Barclays Agency, 6% Bloomberg Barclays Securitized, 2% Bloomberg Barclays U.S. Credit, 4% Bloomberg Barclays Global Agg Ex-USD, 9% Bloomberg Barclays VLI High Yield, 6% Bloomberg 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. Past performance is no indication of future results. Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

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—which inflated in the late 1990s—and the Great Recession of 2007 to 2009. If an investor had held only U.S. large-cap stocks, as represented by the S&P 500®, that portfolio would be worth more than $313,000. Had they invested the same amount in a more conservative blend of 60% stocks and 40% bonds, they’re portfolio would have weathered the market storms a bit better, but would have trailed during the recent bull run ($283,793). 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 $345,204.

The only “free lunch” in finance

Nobel Prize–winning economist Harry Markowitz, the father of Modern Portfolio Theory, 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 Modern Portfolio Theory. 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, international and emerging markets
  • Fixed income: Treasuries, corporate bonds, municipal bonds, international bonds, emerging market bonds and 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.

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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.

Performance may be affected by risks associated with non‐diversification, including investments in specific countries or sectors.

Additional risks may also include, but are not limited to, investments in foreign securities, especially emerging markets, real estate investment trusts (REITs), fixed income, small capitalization securities and commodities. Each individual investor should consider these risks carefully before investing in a particular security or strategy.

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

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

 

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