After the run up in the US stock markets, more and more people are asking why anyone would want to invest anywhere else. The world is falling apart and the US is the ‘least dirty shirt’ or the ‘best house in a bad neighborhood’. Apparently you are stripped of your pundit status if you praise the United States too directly. However cynically they say it, experts think the United States is the only country on the planet that has its act together. After all, the stock market has been going straight up for the last five years. Why would you invest anywhere else?
Diversification is the easy answer that every financial advisor will tell you. It is supposed to lower risk and make the bumpy return line on some chart smoother. In theory, diversification is peachy. In practice, it can be frustrating. That’s because you will have years like 2014, when diversification (away from the S&P 500) mutes returns. Even a diversified portfolio will still experience sizable bumps along the road (2008 being an extreme example). Then again, diversification isn’t supposed to maximize returns or to eliminate downside risk. Rather, adding uncorrelated asset classes to the mix makes it much easier for investors to weather financial crises and resist the call to sell everything and throw money at what worked last year. Diversification allows investors to achieve their financial goals without having to correctly predict “the markets” every day, week, month, or year.
The hardest part of successful investing is not fiddling with a portfolio in reaction to the current headlines. Action is frequently mistaken for skill in the investment entertainment community (CNBC, etc), but stock pickers got destroyed in 2014 (relative to the indexes) in what was supposed to be a stock-pickers market. JP Morgan has an excellent slide in their Guide to the Markets that shows the average investor made just 2.5% annualized over the last 20 years. This sounds impossible, but actually reflects the tendency of humans to sell the asset that is causing them pain and buy the one that looks most comforting. This also happens to be the poisonous formula behind buy high, sell low. JP Morgan also shows a diversified portfolio earning about 8% per year during that same stretch.
The fictional racecar driver Ricky Bobby once said, “If you ain’t first, yer last.” However, investing isn’t a zero sum game. True investors are unconcerned with how well they did versus other people and instead monitor how well they are doing in relation to their financial plan.
From our perspective, talk of performance chasing (“why didn’t we put more into xyz asset class that did well last year” or “why do we have so much in xyz asset class that went down last year”) is a red flag and a contrarian indicator. It sounds similar to 2009 when bonds had outperformed stocks over 10 years – “why would anyone invest in stocks?” The same was said of real estate at that time, too. These asset classes went on to rally hard after investors (turned speculators) capitulated and sold. Rather than selling, it is more prudent to diligently rebalance, selling high and buying low across a diversified portfolio of asset classes. No one knows what will outperform this year or the next. With diversification, an investor doesn’t need to know these things and can eliminate that crystal ball risk.