Practice Smart Diversification

Holding securities across many market segments can help manage overall risk. But diversifying within your home market may not be enough. Global diversification can broaden your investment universe.

Prior to 1950, professional investment managers shunned diversification in favor of securities analysis and concentrated stock picking. According to conventional wisdom, a manager should diligently research individual stocks and choose only a few that offer the best potential to maximize returns. Broad diversification was rejected for concentrated exposure to a handful of stocks.

In 1952, Harry Markowitz introduced the modern investment age with his landmark work on building optimal portfolios through diversification and mean-variance analysis. He explained his theory in a Journal of Finance article titled “Portfolio Selection,” published in 1952. His theory emphasized making investment decisions based on risk, evaluating investment performance at the portfolio level, eliminating specific stock risk through diversification, and holding assets that are not highly correlated. Markowitz constructed a theoretical “efficient frontier” where a set of optimal portfolios offer the best level of return for a given amount of volatility, or the lowest level of volatility for an expected return. The investor should choose a portfolio based on the amount of volatility risk he is willing to take and then identify this diversified portfolio on the curve.

Markowitz’s work predated the powerful computers and returns data needed for practical implementation of Modern Portfolio Theory. But his model set the stage for a new investment approach that was based on a quantitative, risk-aware process. In 1990, he shared the Nobel Prize in Economics with Merton Miller and William Sharpe for their contributions to modern finance.

Many people concentrate their investments in their home stock market. They might consider their portfolio diversified when they choose a large group of US stocks or US mutual funds. Yet, from a global perspective, limiting one’s investment universe to a handful of stocks, or even one stock market, is a concentrated strategy with possible risk and return implications.

The graphic above offers a conceptual comparison of investing only in the US market, as represented by the S&P 500 Index, and structuring a globally diversified portfolio that holds assets in markets around the world, as represented by the MSCI All Country World Index (IMI). For the global portfolio, holding thousands of stocks across the world’s developed and emerging market countries broadens one’s investment universe. A diversified portfolio should be structured to hold multiple asset classes that represent different market areas across the world.

Market, size, and relative price premiums have been documented in markets around the world, including both developed and emerging markets. This suggests that these dimensions of higher expected returns are robust and can be targeted in globally diversified portfolios.

We believe investors should hold globally diversified portfolios in order to achieve broad diversification. Empirical research shows that the international developed markets have historically delivered average returns that are similar to the US market. However, not all countries experience identical returns, and as a result, global diversification is an essential diversification tool.