Why Should You Diversify?

William Suplee |

Over the last five years, U.S. stocks outperformed international emerging market stocks by a wide margin. This has led some investors to wonder why bother diversifying outside of the US markets if the returns here have been substantially better? Sure, there are many reasons to have more money in your home markets. You eat in U.S. dollars, you pay your bills in U.S. dollars and you live in the U.S. economy but this doesn't mean that you should have all of your money in United States markets.

While five years may seem like a pretty good time frame to judge, it’s a relatively small period of time when talking about investing horizons. Over time, non-U.S. stocks will provide valuable diversification by acting differently than U.S. stocks. Recent performance is not a good judge of what the future returns will be. In fact, by almost any valuation metrics, international emerging market stocks are significantly cheaper than their U.S. counterparts even after the selloff in the U.S. during the last quarter of 2018.

The global equity market is huge and represents about half the total investment opportunities in the world. Major international corporations like Toyota, Volkswagen, Royal Dutch Shell, Nestlé, Glaxo Smith Kline are world leaders and offer attractive investment opportunities. Let's take a look at what has happened in the past for investors who failed to diversify into international markets. From 2000 to 2009, Standard & Poor's had its worst 10 years in history. The Standard & Poor's was down 9.1% for these 10 years while the world ex-USA was up 17.47% and the world ex-USA small-cap was up 94.33%. Both of these pale compared to the MSCI emerging markets Index net of dividends that was up 154.28% for the same period. Investors who diversified during this period in international, small, and value stocks did significantly better than investors who stayed just in the U.S. markets.

The problem is there's no systematic way to identify which country will be the next to outperform in advance. There has been little evidence that anyone has been successful in this approach. Since the difference between best-performing and worst performing countries can be significant, the only reasonable way to try to capture these returns is to diversify and rebalance when the opportunity presents itself. Smart approaches to patiently hold global equities so that they can provide diversification benefits yield higher returns over time and forget about the relatively shorter time periods.