The Ugly Truth of Diversification

Most of us have heard the phrase, “Don’t put all your eggs in one basket.” Everyone knows diversification is important to control risk. Through the process of spreading risk across a range of investments, you achieve three important benefits. First, you are less likely to lose a lot of money on any one investment. Second, you may potentially improve the overall risk-return profile of your investment portfolio. Lastly, you are more likely to have a smoother ride over time. In other words, it allows an investor to weather market fluctuations and potentially mitigate losses during times of market turmoil.

Despite its importance, many investors fail to stay diversified, often due to emotions overpowering investing discipline. Inherently, staying diversified typically means something will always be down at any given point in time. Investors can find this difficult to stomach as human nature is to avoid losses and chase the winners. This becomes even more pronounced when investors watch something underperform year after year. The human tendency is to make a change and get into something that has done well over the last years. Typically, this happens at the wrong time.

This was particularly evident in the past year. Going into 2022, the technology sector was coming off several years of red-hot performance. Meanwhile, the energy sector had been struggling. Many investors overallocated to technology as a result of fear of missing out on outperformance. At the same time, many investors gave up on energy and under-allocated to the sector. Unfortunately, the timing couldn’t have been worse. Technology ended the year down -28.91% while energy ended the year as the best-performing sector, returning 59.04%! 

Similarly, growth stocks had dominated over the previous years. Emotions took over and many investors overallocated to growth stocks despite unreasonably high valuations. This did not end well as the Russell 1000 Growth (Large Cap Growth) ended the year down -29.63% while Russell 1000 Value (Large Cap Value) was only down -9.36%. To be clear, Bragg portfolios do own both value and growth stocks because diversifying across both does help to smooth out returns over time. With that said, we do tilt toward value. Why? As highlighted in my article Value Still Beats Growth, long-term historical evidence demonstrates value has higher risk-adjusted returns compared to growth. 

Speaking of recent long streaks of outperformance, take a look at the US vs. international stocks relative performance chart below. As you can see, US stocks are going on 15.3-year run of outperformance relative to other developed countries. The last time period international stocks dominated was 2001 to 2008. Since then, US stocks have led the way. The extended run has prompted investors to question the need for an allocation to international equity in their portfolios. Looking at the chart below, it’s tempting to say, “Let’s get out of international stocks. They are clearly not coming back.” This would be another good example of the aforementioned human tendency to give up on the discipline, most likely at the wrong time.

Additionally, from a valuation standpoint, you can see in the chart below that international stocks are currently trading at a deep discount to US stocks. The current P/E ratio of US stocks is higher compared to the 20-year average while the P/E ratio for international stocks is lower. Although we don’t know if this is the year for international stocks to outperform, given the unusual extended run of US stocks and the lower valuations of international stocks, it is plausible international stocks are due to take the lead. 

As a refresher, it helps to take a step back to remind ourselves why we invest in international equity in the first place. The global equity market is large, with more than 15,000 companies and other investment vehicles all around the globe. With the US being about half of the global market, the other half of the investment opportunity set is outside of the US. It consists of developed and emerging markets. Some of the biggest and most well-known companies are not in their local markets. If investors want to own the largest car company in the world, they must own Toyota, which is based in Japan. Similarly, if they want to own one of the largest ship builders in the world, they must own Hyundai, which is based in South Korea. The point is, by investing exclusively in US stocks, investors miss out on owning some of the best companies in the world.

It is also worth recognizing investors’ tendency to have a home bias. There is a false sense of comfort in being more familiar with domestic companies, yet we daily enjoy the benefits of a globalized world without thinking twice about it. Whether it’s driving a German-made car to work, drinking a cup of coffee made with beans grown in South America, or checking emails on our phone that was manufactured in Taiwan, we use foreign-made products every day.

So, in which country should we invest? To answer that question, it is helpful to remember that history has shown there is not any one country around the world that consistently outperforms. Take a look at the chart below to see how developed countries have performed over the last 20 years. As you can see, predicting the next year’s winner is not an easy task. A perfect example is Austria, which had the highest market return in 2017 only to have the lowest return the following year. Interestingly, the US has only had the highest market return once, in 2014. Moreover, the US has been in the lower half of the performance rankings in almost half of the 20-year time frame. This is why having a globally diversified portfolio can help provide more reliable outcomes over the long term. 

Here at Bragg, we think owning a globally diversified portfolio will provide attractive risk-adjusted returns with lower volatility. History has demonstrated that investors are rewarded when they follow a long-term investment plan, remaining diversified, even when the going gets tough and human nature tries to take over. Our investment committee at Bragg meets weekly to ensure we are sticking to our investment plan. We don’t know if technology will outperform energy this year but we will own both sectors in the portfolio. The same is true of value and growth, as well as US stocks and international stocks. The diversified portfolio will never be at the top of the list in the short term. But over the long term, we think it’s the clear winner. And that’s the ugly truth. 

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.