Does diversification still make sense?

It’s been a difficult year in the markets and it seems there’s been no safe harbour. With interest rates rising to combat inflation and a tense geo-political situation globally, stock and bond markets around the world have been falling.

As you know, diversification is the fundamental strategy for reducing portfolio risk. Noble Prize-winning economist Harry Markowitz famously described it as “the only free lunch in finance.” Markowitz demonstrated that broadly diversifying within and across assets classes and countries allows investors to increase expected returns while reducing risk.

However, it often seems – especially since the financial crisis of 2008-09 – that when trouble strikes, the markets tend to move down together. So, this raises the question: Does it still make sense to diversify?

To answer this question, we turned to a remarkable resource—the Credit Suisse Global Investment Returns Yearbook. It’s a guide to historical returns for all major asset classes in 35 countries, dating back in most cases to 1900.

The 2022 edition of the yearbook includes an examination by financial historians Elroy Dimson, Paul Marsh and Mike Staunton of the power of diversification across stocks, countries and asset classes. Their study of the historical data led them to several important conclusions.

• Globalization has increased the extent to which markets move together, but the potential risk reduction benefits from international diversification remain meaningful.

• The extent to which international diversification can fail investors in a crisis is limited to quite short periods and is relevant only if an investor is forced to sell. “For long-term investors, the enhanced correlations are of less consequence.”

• Over the last 50 years, investing in stocks globally has generated higher reward/risk ratios than investing only domestically in most countries.

• A notable exception has been the United States, where over the last 50 years investors would have been better off investing domestically. This finding reflects the excellent returns and lower volatility of the U.S. stock market during this period. However, the authors also note past performance is no guarantee of future returns. “We are observing these results with hindsight…There is no reason to expect American continued exceptionalism.”

• Investors in smaller markets, especially ones that are highly concentrated in certain sectors, have more to gain from global diversification than U.S. investors because “the U.S. market is already very large, broad and highly diversified.” Canadian investors take note.

• Despite well-known advice to hold a broadly diversified portfolio, the authors highlight academic studies that show most investors are woefully under-diversified. For example, they quote a study (Goetzmann and Kumar 2008) that analyzed more than 60,000 investors at a large U.S. discount brokerage house and found the average holding was just four stocks.

Investors with concentrated portfolios pay for it dearly. A Danish study (Florentsen, Nielsson, Raahauge and Rangvid 2019) analyzed a database for 4.4 million Danish investors and found they could increase their expected return by up to 3% a year by moving from the concentrated portfolio they typically held to an index fund with the same overall risk.

• On asset diversification, the authors write: “Stock-bond correlations have now been mostly negative in major world markets for some 20 years. This negative correlation means that stocks and bonds have served as a hedge for each other, enabling investors to increase stock allocations while still satisfying a portfolio risk budget.”

However, an increase in interest rates is a common variable for both stocks and bonds and this should lead to a positive correlation between them or, in other words, a more limited diversification effect. What’s more, the yearbook notes the correlation between stocks and bonds has been positive for extended periods of time since 1900. So, in the future, the correlation may be positive.

But unless the correlation is perfect, investors will still see the benefits from being diversified in stocks and bonds. And we can’t forget the important fact that bonds are less volatile than stocks.

The yearbook’s authors conclude that “there is a compelling case for global diversification, especially at the current time,” but observe the benefits of global diversification can be oversold if they are presented as a sure-fire route to a superior return-risk trade-off. Diversification should lead to a higher expected level of return for the same risk, but this is not assured.

Therefore, the best we can do is to make well-informed, prudent investment decisions and then patiently stick to our plan, especially when the markets are bleak.