The Diversification Dividend

The world equity portfolio is the most diversified equity portfolio available — or as I described it in my last post, “the cheapest, broadest, most tax-efficient index tracker of aggregate world equity markets” an investor can find.

In order to get a sense of the overall benefits of diversification in a given domestic market, consider the following chart:

As the chart suggests, the incremental benefits derived from diversification begin to decline as more securities are added. This makes sense: stocks trading in the same market will tend to correlate greatly since they are exposed to the same economy, legal system, etc., and after picking a relatively small number of them, you have diversified away most of the market risk of any individual stock.

You could actually gain many of the advantages offered by US index funds by picking 15–20 large-capitalization stocks and sticking with them, assuming they did not all act like large-cap stocks. (If you added only stocks from one sector that all moved in the same way, the diversification benefits would be far lower.) It is not the “rational US portfolio” — if it was, why did you deselect those other stocks? But from a diversification perspective, you have accomplished a lot.

By expanding the portfolio beyond the domestic market, much greater diversification is achieved because the investments are spread out over a larger number of stocks and, more importantly, because those stocks are based in different geographies and local economies.

A Whole New World

Only decades ago, investors did not really have much opportunity to invest across the world. While it is still not a seamless process, investing abroad in a geographically diversified way is easier than it used to be. And there are some great reasons to do it:

• It makes the portfolio as diversified as possible, and each dollar invested in the market is presumed equally clever — a view consistent with what a rational investor believes. I bet many Japanese investors wish they had diversified back in 1990, before the Nikkei commenced its quarter century of roughly -2.6% compound annual returns.
• Because investors are just buying “the market” as broadly as possible, it is a simple portfolio to construct and thus very cheap. You do not have to pay anyone to be smart about beating the market. Over time, the cost benefit can make a huge difference. Don’t ignore that.
• This kind of broad-based portfolio is now available to most investors. Only a couple of decades ago, most people thought “the market” meant only their domestic market or, at best, the regional market. Take advantage of this development to buy broader-based products.

But Can We Improve on This Simple, Rational Portfolio?

Many books and articles on investing suggest that value shares — those with low price-to-book or price-to-earnings ratios — and smaller companies outperform the general market over time. Various indices and products have been created to cater to this argument.

In short, I do not think the rational investor should buy alternative-weighted investments as proxies for market exposure.

By actively deselecting a portion of the market — the higher-growth or larger companies — investors are claiming that the money invested in that market area is somehow less informed than they are, which is a pretty grand statement and one inconsistent with rational investing. It is probably fair to assume that all those investors in the growth or large companies are highly experienced and informed, have read all the relevant books on investing, and are well aware of all aspects of the historical outperformance of various sectors of the markets.

They are not stupid. In fact, they are as much a part of the market as the value or smaller company investors are. Do you really think that the trillions of dollars invested in companies like Google and Apple are somehow ill informed? That you know more about the markets than they do to the extent that you can deselect those stocks?

Do Not Kid Yourself: Be Either Passive or Active

In my opinion, anyone who suggests an alternative weighting to that of the overall market looks a lot more like an active than a passive investor. Likewise, the implicit cost of the part of the portfolio that diverges from the general index can easily approach the fees charged by an actively managed fund. Suppose an alternative-weighted index has an overlap of 66% with the wider market but costs 0.33% more per year to implement. In that case, the investor is paying 1% per year on the part of the investment that is different from the general market — a fee similar to those of some active managers.

I also think that many of these alternative-weighted indices are created to match the best historical performance and are thus easier to sell. If stocks with high P/E and growth rates were the best performers over the past decades, many of the alternative-weighted indices would consist of that market segment, complete with charts outlining all the great reasons why that trend could be expected to continue.

Buyers of that investment would be guilty of fitting the product to past returns and essentially saying that they had the insight that the future would be like the past.

My main issue with small company investing, on top of the active deselection of some parts of the market that it implies, has to do with implementation. Actively implementing a portfolio of smaller companies is very expensive because the execution trades are subject to large bid–offer spreads and price movement if you trade in any size.

Even if you could pass the hurdle of costs, you would still be left with the same question: Do you really know enough about the markets to claim an edge to the extent that you overweight these stocks at the expense of other stocks in the market? What is it you know that the wider market does not?

Whether you are picking a North American biotech index, the Belgian index, or an index of commodities stocks, you are essentially claiming an edge and advantage in the market as if you were picking Microsoft shares to outperform.

In summary, stick with the broadest and cheapest market.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo credit: ©iStockphoto.com/FrankRamspott