Trail Financial Planning, LLC is a fee-only financial planning and investment management firm located in Bellingham, WA

Investing 202: Use diversification as an investment strategy

Investing 202: Use diversification as an investment strategy

Idioms carry and convey wisdom.  This post is could be summed up in eight words:

Don’t put all your eggs in one basket

I like to imagine my grandmother speaking the words; her long life experiences packing the words with a heft greater than the word count.  Wisdom should help guide a philosophy (what you think or believe).  Philosophy should help shape a strategy (how you act or behave).  This post is an exploration of how the multiple baskets idea should form a cornerstone of an investment philosophy, and what investment strategy follows as a logical result.  Since I am a scientist by world-view and training, it is also an exploration of some data that supports such an approach.

Most people would agree philosophically with spreading their eggs out, it is an intuitive concept to protect against risk.  Yet, when I begin to delve into investment strategy with clients, I often receive questions that do not align philosophically.  For example, I was recently asked,

“John, the US stock market has trounced international markets.  Therefore, shouldn’t I just put all of my investment portfolio into a low fee, S&P500 index fund?”

The first sentence is true, at least over the last 10 years or so, and is supported by data (read on for some actual numbers).  But, the second part is a little bit like basing a decision to stop eating fruit-flavored ice cream on the logic, “Every single person who ate fruit-flavored ice cream in 1860 is now dead.  Therefore, eating fruit-flavored ice cream is bad for your health.  You should eat only vanilla or chocolate ice cream.” 

Clearly, the fruit ice cream–>death logic is flawed, or at least the implied cause-and-effect logic is wrong.  However, it is more difficult to evaluate the logic behind the client’s investing question.   The client’s observations are correct (international markets have performed quite poorly of late), and the suggested action (invest in a S&P 500 index fund) is certainly more diversified than making a single bet on Apple stock.  But, the action is a prediction, or an assumption, that the US market will out-perform going into the future.  Research suggests that getting market performance predictions right, for the most part, is more luck than skill.  

The investing I do for myself and my clients is to support future hopes and dreams like helping a child go to college, future wanders through a Moroccan spice market, or tranquil afternoons with a good book at a lake cottage.  I am not interested in “get rich quick” schemes, or investment strategies that rely on a hunch.  I seek an investment strategy that is guided by wisdom, and informed by data.  In this post I am going to argue that there is a data-driven investment strategy that aligns with the philosophy, don’t put all of your eggs into one basket.  In investment jargon, this idea is called diversification.  Read on to explore why, and how.  


This post is part of a 6-part series on developing an investment process.  The other posts in the series are:  

Investing 101 – Why invest?  Create a process and a plan

Investing 102 – When?  Use your emotions to fuel your why, and when you need the money temper them

Investing 103 – What?  What should you invest in?  

Investing 201 – What if?  Risk and return in the stock market.  What is right for you?

Investing 202 – How to create diversification in an investment strategy.  (this post)

Investing 301 – How?  Create a comprehensive investing strategy.  (future blog post)


What is diversification?

Diversification is not complicated, but it is nuanced.  Consider Don Gorske, the famous binge-eater of Big Macs, who was made famous in the movie, Super Size Me.  

 

Don Gorske has eaten thousands of Big Macs

By one account, you could say that Don eats a very concentrated diet – over 29,000 Big Macs and counting.  Eating the same food meal after meal, day after day, is not a diversified diet.  Yet by another reckoning, you could look at the components of a Big Mac – bread, meat, cheese and vegetable – and say that blocks of the food pyramid are there.  A more important question may be whether the diet is healthy.  On one hand, Don appears healthy.  However, when the Morgan Spurlock, the film-maker of Super Size Me, tried to eat nothing but fast food for 30 days, the results on his health were so alarming that his doctor wanted the film-experiment stopped immediately.  This story suggests a few things:  1)  Concepts of diversification can be nuanced, 2) When choosing a strategy based on statistics, the outcome may not turn out the way that statistics suggest (there are anomalies), and 3) Don’s diet and hair are both individual and awesome, yet neither should be aspired to by most people.  

Concepts of diversification can be nuanced

Within the investing world, there is also a nuanced way to look at diversification.  Most people would argue that placing a bet on a single investment, such as a gold coin, a share of Apple, or even hiding money under the mattress would be an undiversified (or concentrated) investment.  However, one COULD argue that Apple, as a globally diversified company, has its own level of diversification, selling various products and services to people all around the world.  From an investment perspective however, Apple’s share price is one number, and the risks associated with one number rising or dropping are substantially higher than a diversified basket of stocks like the S&P 500.  So, a single stock (or bond) is a concentrated position. 

The level of diversification of an investment may be ranked from low to high:

Graphic created by John Chesbrough

Consider two different “mutual fund investments,” the US-based S&P 500 and the global, MSCI ACWI market index (see endnote [1] for acronym meaning).  The graphic below illustrates how the the indexes are different. 

Image courtesy of Dimensional Fund Advisors.  (See endnote [3] for data notes and source)

The S&P 500 is an index based on 500 largest company stocks listed on the New York stock exchange.  The Global Market Index Portfolio is composed of 8,722 stocks, and includes the S&P500 companies (gray bar at top), but many others as well (like another 8,217 companies).  Both portfolios are diversified, but the Global Market Index Portfolio is substantially more so.  

When choosing a strategy based on statistics, the outcome may not turn out the way that statistics suggest (there are anomalies)

Wearing a seat belt, on average, gives you a much higher chance of survival in an automobile wreck.  But, I’ve watched the Road Warrior and Speed.  Mel Gibson and Sandra Bullock didn’t worry about buckling up.  They are cool.  In addition, I have a story bouncing in my head of driver whose car ran off the road and plunged into a lake. The driver couldn’t get out of his seat belt and so drowned.  The story is probably an urban myth.  Or maybe not.  I have no idea.  My point is that culture and the media have threads of an “anti-seat belt” story line.  Those stories could push our behavior to act in opposition to what statistics say gives you the best odds at doing well.  Fortunately, laws and other prevailing wisdom has made wearing seat belts a non-negotiable.  Despite some bad story lines, I behave in a way that aligns with my best interest.  

Within the investing world, I’ve heard diversification called di-worseification, meaning that a diversified portfolio could lead to worse investment performance.  Usually, the person goes on to quote a case study such as “If you’d just put all your money into Apple stock rather than the S&P500, you would have 50 times more money now.”  Although true, it is cherry picking historical data.  Anybody with a time machine can produce great investing results.  This tendency we have to cherry pick data is often subconscious, rooted from a human tendency to look at what has happened in the near term, and extrapolate it into a “new normal.”  In behavioral science, this phenomenon has a name – called recency bias.

Don’s hair is amazing and awesome

Also true!  After you’ve forced your way through my blog post, treat yourself to a bowl of blueberry ice cream, and check out some links to some REALLY awesome hair.  I was recently introduced to the “Minnesota State High School All Hockey Hair” AKA “Minne-Flow-Ta.”  It’s amazing.  But finish this blog first! 

Historical data – has the US stock market out-performed other markets?

Short answer:  It depends on when you compare.  Yes, over the last ten years.  However, in other decades the answer is no.   If your lens is the last ten years, then US markets have soundly out performed international markets.  This is true for both stock and bond markets.  For example, consider the Vanguard S&P500 Index (Symbol: VOO), representing the US stock market (at least the large companies), and the Vanguard FTSE all world ex-US index (Symbol:  VEU), representing the international stock market outside of the US.  Over the last five years, the US-based investment returned 10.6% per year, while the international investment returned only 2.4% per year.  Since 2010, there has been a similar disparity. (See endnote [3] for important disclosures about the data).  Bond markets have shown a similar US out performance, though with a smaller difference.  Thus, over the last decade, it is true that the US market has trounced the international markets.  

There are many reasons for the out-performance:  economic policy, business culture, politics, investor sentiment, taxes, a strong university research base are but a few of the reasons.  It is nearly impossible to suss out one cause over another.  It’s like looking at a rain drop and then looking for the the exact cloud it came from.  Certainly, the drop came from one of the clouds in the sky, but which cloud exactly would be very difficult to tease out.  Better to just open an umbrella, or cast your face upwards and enjoy the gifts of the water cycle. 

However, when the time lens is widened, the dominant US market narrative becomes more suspect.  For example, the years 2000 – 2009 are sometimes called the “lost decade” by investors in US markets.  This particular span of 10 years was the worst 10-year performance of the S&P 500 index, it returned a cumulative -9.1%.  Meanwhile, most markets outside of the US returned positive returns.  Looking further into the historical records, for the 11 different decades from 1900 to 2010, the US outperformed global markets in five decades, while global markets outperformed US markets in six (see endnote [4] for data source and notes).   

What can historical data tell us about the future?

Historical data can be informative.  But, there is an important caution that reputable companies (such as Vanguard) always write to accompany performance data:  Past performance is not a guarantee of future returns.  Those words are repeated so often that they may have become like my wife’s mantra to our son:  “Be careful.”  True enough, but repetition has paved over any wisdom that may have once existed.   Will the US out-perform international markets going forward?  That is the proverbial million-dollar question.  Let’s look at some other data to help guide the question. 

Figure 1.  Relative investment performance of different market segments over time

Graphic courtesy of Dimensional Fund Advisors.  (See endnote [5] for data notes and source).  It should be noted that a high return in one year may have actually been bad, even negative.  These are relative returns.

Discussion of Figure 2:  I love this image.  Each year is a stacked column, with each colored block a different type of investment (or area of investment), ranked in order from the lowest annual return (at the bottom) to the highest annual return (at the top).  The first task I ask my clients (or myself) to do with this image is, “Find a pattern to this data.”  It’s an unfair question, because performance patterns should need statistics, and this image does not provide nearly enough data to do any sort of statistical analysis.  But, we humans are hard-wired to look for patterns – the seasons, wildebeast migrations, a deep growl from the brush = run, etc.  After a few moments of contemplation, most people usually reach the same conclusion: 

“Ugh, no pattern?” 

I respond, “I agree, there is no pattern.”

What does the “no pattern” suggest?  It suggests that predicting the future performance in one segment of the market vs. another is unpredictable, unreliable, and therefore unworthy of basing an investment strategy on.  Putting all of one’s eggs into one basket over another (such as in the S&P 500 and not in international markets) is inherently a strategic bet that there is a pattern to US returns vs. international returns, and that the US will continue to outperform.  Rather, I think an investment strategy of broad, global diversification makes better sense for the majority of investors’ long-term investment dollars.      

Are there persistent reasons to expect the US markets to out-perform?

Maybe.  The United States has a very strong business environment, and an entrepreneurial culture.  Individual freedoms are paramount.  A strong academic research system helps drive future innovations and business development.  These are some of the reasons so many people want to immigrate to this country (both historically, and in the present), including my grandmother a century ago from Italy.  It IS likely that US businesses will continue to flourish. 

But, who else knows this?  Everybody.  Investors.  The market.  It is already priced into the value of stock markets around the world.  The images below present the relative value of stock and fixed income markets (AKA stocks and bonds) around the world, where the area of each rectangle represents the value of the country’s market. 

Figure 2.  Value of stock markets (equities) around the world shown by area of rectangle.

Graphic courtesy of Dimensional Fund Advisors  (See endnote [6] for data notes and source)

Discussion of Figure 2.  The map shows that the US has the largest stock market (by value).  Yet, nearly 50% of the world’s stock market wealth is outside of the US. 

Investors are “forward thinking.”  When you invest money, you are hoping that the investment will provide future investment returns.  By looking at the entire global market, we can gauge the collective intelligence of the world’s pool of investors – from the investment managers of the gigantic investment funds of California’s pension system to the solo counselor in Bellingham who is contributing to her individual 401k.  Each investor has a bit of a say in market prices.  When they buy or sell an investment, the price of an investment moves in according to supply and demand.  Thus, the current market sizes of an individual company, or global market, tell us what the global storm of investors are expecting for the future.  

Fixed income (or bonds) in even more diversified:

Figure 3.  Value of bond markets (fixed income) around the world shown by area of rectangle.

Graphic courtesy of Dimensional Fund Advisors (See endnote [7] for data notes and the source)

Discussion of Figure 3.  The bond market is even more broadly diversified around the world than the stock market.   Interest rates and credit risks can be different in different places.  So, while our news media may focus on interest rates in the US, there is a world of opportunity for investment in fixed income.  Again, I don’t advocate for a pick-and-choose strategy.  I let the market inform me, and set up a globally diversified fixed income strategy (for long-term investment only, short- or intermediate-term investments deserve their own approach).

What is a globally diversified investment strategy?

My core investment philosophy is rooted in what is known as “the efficient market hypothesis.”  Here is the idea:  Investors are constantly buying and selling securities around the world based on innumerable sources of information. When future investment returns look promising, investors put their dollars towards it, thereby driving up the price.  When future investment returns start to look worse, investors sell, allowing the price to shift downward.  Investment prices are pushed and pulled by millions of market participants.  It’s basically the “wisdom of the crowds.”  An efficient market hypothesis suggests that the current market price is the most fair price for an investment available.  My core investment philosophy is to not try and out-guess the crowds.

My core investment strategy for long-term funds is to create a globally diversified investment portfolio; one that is highly diversified and low in fees.  One mechanism to do so is to use passivley-managed index funds that just track a market (say the entire US stock market, or emerging markets) by owning a proportional bit of every listed stock within said market.  Vanguard was one of the first to provide such funds, although there are many options now.  There is some evidence that certain areas have done better than others over the long-term.  If there is statistically relevant evidence for any persistent out-performance over very long-term time frames,  I am interested.  Dimensional Fund Advisors (DFA), a data-driven investment firm, has identified only a few factors within the market that have shown persistent, higher performance.  DFA calls them the Dimensions of Higher Return.  To read more about the individual factors, and the evidence for their out-performance, please contact me, or you can learn more on your own by:

Watching a five minute video:  Foundations of Dimensional Investing, video 1

Or, you can read more about the investment strategy at:  Dimensional Fund Advisors US website 

I use both passively-managed index funds and DFA funds to build and maintain a core investment portfolio for my clients and my own family.  Your financial need, your time-frame, your risk tolerance, and your values should all be brought into a comprehensive investment plan.  And though investing offers a compelling case to participate the amazing rewards of compounding growth, it carries inherent risk.  Diversification can be one strategy to help reduce the risk, and participate in the growth of markets wherever it occurs in the future.  As my grandmother might say, “John, eat your peas AND your ravioli” or, don’t put all your eggs into one basket

Disclosure:  Diversification does not eliminate risk.  When investing in markets, there is a very real chance that the value of your investments may go down.   A globally diverse investment strategy is appropriate for long-term time frames, and should not be considered a “get rich quick” scheme.  If you are looking to get rich quick, I’d suggest looking for  

For further reading

Do you want to check out another source for the case for a globally diversified portfolio?  Ted Dinucci wrote a nice piece that is published on the Vanguard blog site.  It is a worthy read, and has some other nice graphs about the “dampening” effects of diversification.

The case for global equity investing (and a happy marriage)

You made it all the way to the end!  Time for ice cream and Minn-e-FLOW-Ta.  It’s worthy entertainment, though you may have to skip through some ads to get to it. 


Endnotes

If you would like to see the entire presentation for any of the graphics sourced from “Dimensional Fund Advisors (DFA) source materials” please email the author at john@trailfp.com.  He will happily send you a copy of the presentation.

[1] MSCI AWI stands for Morgan Stanley Capital International All World Index and is comprised of stocks from 23 developed countries and 24 emerging markets.  Source:  Investopedia  

[2] Performance data is from the Vanguard company website.  Historical presentations of performance data should be read with care, and of course historical data is not a predictor of future performance.  Please refer to the website for important disclosures about how to interpret historical performance data.   

Performance data for VOO comes from https://investor.vanguard.com/etf/profile/performance/voo

Performance data for VEU comes from https://investor.vanguard.com/etf/profile/performance/veu

[3] Source:  Dimensional Fund Advisors (DFA) client presentation materials.  DFA’s main website may be found at: https://us.dimensional.com/.  DFA’s disclosures:  Number of holdings and countries for the S&P 500 Index and MSCI ACWI (All Country World Index) Investable Market Index (IMI) as of December 31, 2018. S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. MSCI data © MSCI 2019, all rights reserved. International investing involves special risks, such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.

[4] Source:  “Why Should you Diversify?”  December 2018, Dimensional Fund Advisors (DFA) investment research materials.  DFA’s main website may be found at: https://us.dimensional.com.  DFA’s disclosures about the data:  2. Source: Annual country index return data from the Dimson-Marsh-Staunton (DMS) Global Returns Data, provided by Morningstar, Inc.   

[5] Source:  Dimensional Fund Advisors (DFA) client presentation materials.  DFA’s main website may be found at: https://us.dimensional.com/.  DFA’s disclosures:    In USD. US Large Cap is the S&P 500 Index. US Large Cap Value is the Russell 1000 Value Index. US Small Cap is the Russell 2000 Index. US Small Cap Value is the Russell 2000 Value Index. US Real Estate is the Dow Jones US Select REIT Index. International Large Cap Value is the MSCI World ex USA Value Index (gross dividends). International Small Cap Value is the MSCI World ex USA Small Cap Value Index (gross dividends). Emerging Markets is the MSCI Emerging Markets Index (gross dividends). Five-Year US Government Fixed is the Bloomberg Barclays US TIPS Index 1–5 Years. S&P and Dow Jones data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. MSCI data © MSCI 2019, all rights reserved. Bloomberg Barclays data provided by Bloomberg. Chart is for illustrative purposes only. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.

[6]  Source:  Dimensional Fund Advisors (DFA) client presentation materials.  DFA’s main website may be found at: https://us.dimensional.com/.  DFA’s disclosures:  In US dollars. Market cap data is free-float adjusted and meets minimum liquidity and listing requirements. Dimensional makes case-by-case determinations about the suitability of investing in each emerging market, making considerations that include local market accessibility, government stability, and property rights before making investments. China market capitalization excludes A-shares, which are generally only available to mainland China investors. Many nations not displayed. Totals may not equal 100% due to rounding. For educational purposes; should not be used as investment advice. Data provided by Bloomberg.

[7]  Source:  Dimensional Fund Advisors (DFA) client presentation materials.  DFA’s main website may be found at: https://us.dimensional.com/.  DFA’s disclosures: Data is from Bloomberg Barclays Global Aggregate Ex-Securitized Bond Index. Index excludes non-investment grade securities, bonds with less than one year to maturity, tax-exempt municipal securities, inflation-linked bonds, floating rate issues, and securitized bonds. Many nations not displayed. Totals may not equal 100% due to rounding For educational purposes; should not be used as investment advice. Bloomberg Barclays data provided by Bloomberg.

John Chesbrough
john@trailfp.com

I am a financial planner and investment manager. I also am the owner of a fee-only, independent financial advisory firm called Trail Financial Planning. I enjoy working with people who care for others and their community – parents, firefighters, therapists, doctors, nurses, and teachers. I may be spotted at through my blog or on the many winding trails of Whatcom County. To learn more, or contact me directly, please visit my firm's website: www.trailfp.com.