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 U.S. trade tariffs to Brexit to the current political climate in the U.S. 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 the World Bank, the U.S. share of world gross domestic product was only 24% in 2018 and the U.S. accounted for roughly 44% of world stock market capitalization (a measure of how much capital is invested in stock markets).
Do you really want to limit your investment opportunities? 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 that emerging market and international stocks were the top performing asset classes in 2017 (37.8% and 25.6% respectively)—but emerging markets were at the bottom in 2018, and international was near the bottom.
The chart shows that U.S. large-cap stocks were the top performer over the entire 2009-2019 time period. This does not imply that U.S. large caps are the best investment. Over the so called “lost decade” for U.S. stocks (2000-2009), U.S. large-cap stocks did not finish among the top five asset classes in any calendar year and was the worst-performing asset class over the period.
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
*YTD as of September 2019
Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. Data is from January 1, 2009, to September 30, 2019. Asset class performance is represented by annual total returns for the following indexes: S&P 500® Index (U.S. Large-Cap), Russell 2000® Index (U.S. Small-Cap), MSCI EAFE® Index -Net of Taxes (Int’l Developed), MSCI Emerging Markets IndexSM (Emerging Markets), S&P US REIT Index (US REITs), S&P Global REIT Ex-US Index (GLB. REITs), S&P GSCI® (Commodities), Bloomberg Barclays US Treasury Inflation-Linked Bond Index (TIPS), Bloomberg Barclays US Aggregate Bond Index (Core Bonds), Bloomberg Barclays VLI High Yield Bond Index (High Yield Bonds), Bloomberg Barclays Emerging Markets USD Aggregate Bond Index (EM Bonds), Bloomberg Barclays Global Aggregate Ex-US Bond Index (Int'l Dev Bds.), FTSE U.S. 3-month Treasury Bill 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 3-7 Yr, 1% Bloomberg Barclays US Agency, 6% Bloomberg Barclays US Securitized, 2% Bloomberg Barclays U.S. Credit, 4% Bloomberg Barclays Global Agg Ex-USD, 9% Bloomberg Barclays VLI High Yield, 6% Bloomberg Barclays EM Aggregate, 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. Short Treasury 1-3 Mo. 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 geopolitical 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 “market realities” that are likely to persist for the foreseeable future. Increased globalization and interconnectivity, increased bouts of 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.
Successful investors focus on expected future performance, not what has happened in recent past. As the data below illustrates, there are potentially attractive investment opportunities outside the U.S. Our long-term capital market return expectations indicate that international stocks have higher expected returns than U.S. large-cap stocks over the next 10 years.
Source: Charles Schwab Investment Advisory, Inc. and Thomson Reuters IBES data as of 12/31/2018. Past performance is no guarantee of future results. There can be no guarantee of forecasted returns and individual clients will experience different results. The return estimates shown here do not consider program fees or other costs and expenses.
If you don’t invest globally, you’re not only narrowing your opportunity set, and potentially decreasing your expected return, 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 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
Source: Schwab Center for Financial Research, with data provided by Morningstar, Inc. Time period examined is from January 1, 2001 to September 30, 2019. Stocks are represented by total annual returns of the S&P 500® Index. The 60/40 portfolio is a hypothetical portfolio consisting of 60% S&P 500® Index stocks and 40% Bloomberg Barclays US 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 3-7 Yr, 1% Bloomberg Barclays US Agency, 6% Bloomberg Barclays US Securitized, 2% Bloomberg Barclays U.S. Credit, 4% Bloomberg Barclays Global Agg Ex-USD, 9% Bloomberg Barclays VLI High Yield, 6% Bloomberg Barclays EM Aggregate, 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. Short Treasury 1-3 Mo. Including fees and expenses in the diversified portfolio would lower returns. The portfolios are 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 no guarantee of future results.
Although past performance is no indication of future results, it is informative to consider historical results in order to illustrate the value of diversification. To do this, we 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 $327,034. Had they invested the same amount in a more conservative blend of 60% stocks and 40% bonds, their portfolio would have weathered the market storms a bit better, but would have trailed during the recent bull-run ($313,078). 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 $354,295.
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, we continue to experience bouts of volatility and ever-changing correlations around the globe, 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
- Non-traditional 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.
What You Can Do Next
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