For years, investment professionals have highlighted diversification’s benefits. Yet, the concept itself is often oversimplified or misinterpreted. What does it mean? What does proper diversification look like? Fisher Investments thinks it is necessary for investors to understand diversification to help construct a stock portfolio that balances risk and opportunity—and avoid common pitfalls, too.
In our experience, some think this concept applies to asset allocation only, meaning ownership of different asset classes—stocks, bonds, cash or other alternatives—equates to proper diversification. Yet the two are distinct, in Fisher Investments’ view, and the difference isn’t semantic. Your asset allocation should be based on your investing goals, time horizon, cash-flow needs and comfort with volatility. It is about targeting the kind of long-term investment returns you need to finance your goals and objectives. Sometimes, an entire asset class is unnecessary because it doesn’t actually reduce expected volatility or increase long-term return potential—like gold. It is also possible to blend several asset classes without attaining diversification. You see, in Fisher Investments’ view, diversification is about having varied exposure within each portion of your asset allocation. In a stock portfolio, that doesn’t just mean limiting your exposure to any one stock, but also seeking to ensure you aren’t overly concentrated in a few areas.
To Fisher Investments, investing globally is key to proper diversification. In our experience, Americans tend to own mostly US stocks—a mistake, in our view. The US contributes only 23.9% of global GDP, and while its 68% of global market cap is high, Europe and Asia play large roles, too. [i] Other countries hold comparative advantages in certain industries relative to the US. For example, Germany’s strength in Pharmaceuticals provides advantages in medicine development, while Australia’s abundance of mines gives an advantage in Materials production. America’s Tech and Tech-like giants are central to our markets. Country leadership shifts regularly in global markets, so investing in just one or a few countries can mean missing opportunities.
More broadly, diversifying globally spreads economic and political risk, or risk associated with big legislative changes to taxation, property rights or other regulations. Every country has a varying degree of risk and opportunity on this front, so global diversification ensures your portfolio doesn’t depend on the whims of a single government. Emerging Markets can have fragile political institutions, carrying more risk than more-developed world governments. However, an emerging nation undertaking pro-growth reforms could present good opportunities. Of course, global portfolios won’t always outperform US-only. Again, leadership rotates. Over long stretches, all similarly broad benchmarks tend to perform similarly—global simply means a broader opportunity set and fewer big booms and busts than single-country portfolios are likely to have, in Fisher Investments’ view.
Investors might struggle to visualize how a global portfolio should be spread out. Fisher Investments thinks looking at country representation within a broad index like the MSCI World Index is a good start. The US is its largest weighting, with Japan and the UK following at about 6% and 4%, respectively. [ii] You can dig deeper with index “Fact Sheets” on MSCI’s website. The weightings can be a rough blueprint for your own portfolio, perhaps with a little more or a little less exposure to areas you foresee performing better or worse, respectively.
We also think a globally diversified portfolio can hold a few dozen companies, yet still lack adequate diversification. How? If they are all in one or two sectors. Stocks typically perform a lot like their sector because companies typically respond to similar drivers. If certain drivers struggle, many stocks in that sector can suffer. For example, global oil prices are a main driver for Energy stocks, so overexposure to Energy during an oil crash could really hurt your portfolio. We saw many investors make the same mistake in the mid-2010s, loading up on Energy stocks, pipelines and the like, not realizing they all are oil-price sensitive. In the late 1990s, investors made the mistake of loading up on dot-com stocks. Such moves work on the upswing, but they can shatter portfolios on the way down. Yes, this is an extreme example, but there is often a big difference among sector returns over a given period. Economic growth rates, credit access and where you are in the market cycle can all cause vast disparities among sector returns.
Here, too, investors can use index weights as a guide. The MSCI World’s sector weights—also on the Fact Sheet—are led by Information Technology and Health Care, clocking in at 21% and 14%, respectively. [iii] You can imagine these weights as a leash, keeping you disciplined and less likely to own too much or too little of one sector. Finally, investors can balance geography and sectors using a country’s specialization to know where to shop for stocks in select industries. Using earlier examples, you may wish to look at German firms if you are targeting exposure to Europe and Health Care.
Diversification simply means much more than owning a slew of stocks or blending your assets across many different types of investments. It means carefully considering how the various parts of your portfolio should work in concert.
Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns. Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations. The foregoing constitutes the general views of Fisher Investments and should not be regarded as personalized investment advice or a reflection of the performance of Fisher Investments or its clients. Nothing herein is intended to be a recommendation or a forecast of market conditions. Rather it is intended to illustrate a point. Current and future markets may differ significantly from those illustrated herein. Not all past forecasts were, nor future forecasts may be, as accurate as those predicted herein.
Sources:
[i] Source: World Bank and MSCI, as of 07/08/2022.
[ii] Source: MSCI, as of 07/12/2022.
[iii] Ibid.