Why You Should Diversify Your Portfolio Across Stocks, Countries and Asset Classes

According to the Credit Suisse Research Institute‘s most recent Global Investment Returns Yearbook, “Diversification allows us to either reduce risk for the same level of expected return or increase expected returns for the same level of risk” [and below are their] arguments…for diversifying across stocks, across countries, and across asset classes.

Stock Diversification

In the first panel, below,

• the dark blue line shows the market risk for all stocks traded on the New York Stock Exchange from 2011 to 2020: that is, the standard deviation of the return in a given year is plus or minus about 20% and
• the lighter blue line looks at the risk of portfolios that include one stock, two stocks, three stocks, and so on up to 25 stocks–with these portfolios chosen at random.

Because diversification means that random winners and losers will tend to balance each other out, a portfolio with more stocks will tend to have less risk, gradually approaching the risk of the market portfolio.

The authors write:

Conventional wisdom is that a small number of stocks – say 10 to 20 – is sufficient to provide market-mimicking returns. That interpretation is misleading … Many more stocks are needed to create a well-diversified portfolio….The right-hand side of the graph above shows a fall in unsystematic risk as the number of stocks is increased…[but] that, even with 100 stocks, the tracking error is still 3.3% per annum. …

Despite the longstanding and widespread advice to hold well-diversified portfolios…[an analysis of the portfolios of], more than 60,000 investors at a large U.S. discount brokerage house…[revealed that the] average holding was four stocks (the median was three) [with only 5% of the portfolios having more] than ten stocks. The level of under-diversification was greater among younger, low-income, less educated and less sophisticated investors.

There are large costs to being under-diversified…

• 57.4% of U.S. stocks have had lifetime buy-and-hold returns below that on Treasury bills [with only 4% of the stocks explaining the net gain for the entire U.S. stock market since 1926…driven by very large returns for the relatively few stocks.
• [An analysis of] some 64,000 stocks from 42 countries showed that the same pattern held for non- U.S. stocks.
• The average individual with a concentrated portfolio is thus likely to receive less than the return on the overall market.

Country Diversification

Below is a figure showing the share of different countries in global equity markets in 1899 and at the start of 2022. In 1899, the U.S. accounted for 15% of all global equity markets; by the start of 2022, the U.S. was about 60% of all global equity markets…

The dramatically different results for U.S. equity markets imply that:

• if you were outside the U.S. economy and invested in U.S. stocks that was an excellent move to diversify but,
• if you were inside the U.S. and thinking about investing outside the country, the potential results from diversifying to other countries are much smaller, or negative.

Dimson, Marsh, and Staunton write:

From 1980 onward, U.S. investors made increasingly large investments in overseas
equities. However, in risk-return terms, they would have been better off staying at home. … Moreover, this is before taking account of the higher costs of investing internationally in the earlier part of this period.

For a U.S. investor, domestic investment beat global investment over these … periods for two reasons.

1. First, U.S. equities performed exceptionally well.
   • Over the 48 years from 1974 to 2021, U.S. stocks beat non-U.S. stocks by 1.9% per year.
   • Over the 32 years since 1990, the outperformance was even greater at 4.6% per annum…
2. Second, over this period, global diversification failed to lower volatility for U.S. investors. The U.S. equity market was among the world’s least volatile as its size, scope and breadth ensured that it was highly diversified.
   • Over the 1974–2021 period, the equally weighted average SD [standard deviation] of non-US countries in the world index was almost double that of the U.S. market. U.S. investors had less to gain from risk reduction than their foreign counterparts.

In addition,

• a number of large U.S. firms had much more involvement in global markets in recent decades: thus, by investing in the stock of those U.S. firms, an investor was in effect, if indirectly, diversifying across countries to some extent. Conversely, deciding to buy stock in foreign markets directly involves various transaction costs as well as exposure to currency fluctuations, regulatory changes, and political risks.

Asset Class Diversification

…The correlation between returns on stocks and bonds has shifted substantially in the last 20 years or so.

• The darker blue line [in the graph below] shows correlation between returns on stocks and bonds for the US and
• the lighter blue line for the UK.

The key point here for most of the 20th century, returns on stocks and bonds were positively correlated, but starting around 2000 they have been negatively correlated, especially in the U.S..

From a standpoint of diversification, a negative correlation between stocks and bonds is very helpful: gains in one will tend to offset losses in the other, and vice versa…

The above version of the original article by Timothy Taylor (conversableeconomist.com) was edited [ ] and abridged (…) to provide you with a faster and easier read. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.

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