Investing in the stock market it is important to diversify across different asset classes and into a broad cross-section of market sectors.
For Broader Diversification, Consider Global Stocks
With the stock market teetering near its all-time high, investors are getting nervous about increased risk. Most investors know that a good way to manage risk and portfolio stability is through diversification. Through diversification, the risk exposure that might be inherent in any one security is spread over many different securities so that a decline in the price of one won’t necessarily affect the whole portfolio. And, because different classes or sectors of securities can tend to act similarly, it is important to diversify across different asset classes and into a broad cross-section of market sectors.
For instance, energy stocks might perform well in times of rising inflation, but financial stocks tend to come under pressure in inflationary periods. The opposite is true during times of low inflation. So, it would be important to own shares of stocks in both industries to moderate the impact of inflation one way or the other.
Also, certain asset classes tend to react differently to one another under various economic or market conditions. For instance, when the U.S. dollar declines gold prices tend to rise because gold is seen as a hedge against a falling dollar. But a declining dollar is typically reflective of a weakening economy which could trigger lower stock prices. So, some combination of gold and stocks will offset the adverse movements of each.
You May not be as Diversified as You Think
While most investors understand that diversification can be essential to effective risk management and can help in long-term investment success, many aren’t nearly as diversified as they might think. In fact, most people might be surprised to learn that U.S. stocks comprise slightly more than half of the global economy. So, when they invest in mutual funds that focus on U.S. companies, they are under-diversified when it comes to global investing.
To a great extent, your portfolio has more exposure to volatility when you limit it to U.S. stocks. The randomness of the market returns across all global equities increases the volatility of returns in portfolios with limited global diversification. At any given time, the global markets, which are comprised of emerging and developing countries and regions, tend to act contrary to one another and the U.S. markets.
U.S. Stocks Won’t Always be Your Best Bet
With the unprecedented run up in U.S. stock prices in recent years, U.S. investors may feel that U.S. stocks are still the best bet, but that has not always been the case. Global stocks have outperformed U.S. stocks for extended periods of time, most recently from 1983 through 1988, and again from 2002 through 2007.1
Because it is difficult to know how any particular market will perform at any given time, global diversification can help your portfolio capture returns wherever and whenever they occur. Global diversification may actually increase return opportunities by further managing risk/return tradeoff. Not to mention that, generally, foreign equities may be more attractively valued than U.S. equities in light of the significant run up in the US stock market.
How Much in Global Stocks is Enough?
While any allocation percentage should be based on individual objectives and tolerance for risk, many investment advisors agree that 15 to 20% is a good baseline. According to researchers at Vanguard Group, once your global stock position exceeds 40%, you don’t receive any additional diversification benefit. Their research suggests that a 20% allocation delivers 85% of the diversification benefit, making it a reasonable start.
1SeekingAlpha.com. US vs Global Stocks Rolling Return Comparison. May 17, 2017
Read other situation analysis articles