The Importance of International Diversification

International diversification

With a seemingly constant drip of bad news from around the globe—military conflicts in Eastern Europe and the Middle East, the spread of Ebola, slowing economic growth in Western Europe and many emerging markets—it may feel that the US is the only safe place to invest your money. But not having enough exposure outside the US means not enough diversification, and that can actually mean higher risk and potentially lower returns over the long run.

The performance of international stocks is driven by some of the same factors that affect US stocks. An upturn or downturn in the global economy, for example, may have an impact on stocks from all countries. But there are plenty of other things that can affect stocks in some countries but not others, such as different valuations, different economic growth rates, different demographics, and different political environments.

These differences mean that international stocks often don’t move in lockstep with US stocks. US stocks substantially outperformed international stocks in 2013, for example, but actually underperformed in 2012 despite the economic woes of the euro zone. Having exposure to both the US and to international markets therefore can mean fewer large ups and downs for your entire portfolio.

Despite overseas wars and economic weakness abroad, the benefits of a globally diversified portfolio may become even more apparent in the coming years. As we’ve noted before, US stocks currently appear to be slightly overvalued by historical standards. This fact doesn’t necessarily mean that US stocks will do poorly, but it increases the chances that their future returns will be below average.

Valuations on international stocks, by contrast, appear to be more in line with historical norms. Strategists at Research Affiliates project that over the next 10 years, current valuations will reduce the returns on US stocks by an average of 1.5% per year. For international developed stocks they think this number will only be 0.6% per year, and for emerging market stocks they think current valuations will actually increase returns by an average of 0.4% per year. Not having enough international exposure, in other words, could mean more risk and less reward.

Understanding Diversification

Pie Chart

Having a diversified portfolio is one of the keys to successfully managing your wealth. But while the idea of diversification may seem simple—putting all your eggs in one basket generally isn’t a good idea—it’s often misunderstood.

Simply having a lot of different investments doesn’t necessarily mean you have a diversified portfolio. Having a large number of stocks that are all in the same sector of the market—a lot of technology stocks, for example—doesn’t offer much diversification: if something happens to that sector, all of the stocks could decline at the same time.

Even having a large number of funds (which offer more diversification than individual stocks or bonds) doesn’t guarantee you’ll have a well-diversified portfolio. If all the funds have similar characteristics, they’re likely to all rise and fall at the same time. In other words, even if your eggs are in different baskets, it won’t do you much good if the baskets are all tied together.

So if the raw number of different investments doesn’t matter, what does? The goal of diversification is to lower the overall risk of a portfolio by putting together different investments that don’t all go up or down at the same time. A well-diversified portfolio will therefore have a mix of different asset classes, different stock sectors, different bond sectors, and different regions of the world. A portfolio that’s too concentrated along any one of these dimensions is not well-diversified, no matter how many individual investments in contains.

Meeting Your Income Needs with a Total Return Approach

If you need to generate income from your investment portfolio to pay for expenses, the process of selecting investments can seem a lot more complicated. Since almost all bonds, many stocks, and some alternative investments provide periodic income in the form of interest or dividends, almost any portfolio will generate some cash. But in the current low interest rate environment, there aren’t many investments that yield more than a few percentage points.

Instead of trying to generate enough income by limiting your choices to only high-income investments, a better tactic may be a “total return” approach.  This philosophy suggests ignoring your income needs when choosing your investments, and instead focusing only on selecting investments that create the portfolio most likely to have the highest total return (i.e. the combination of income and capital gains) for the amount of risk you’re willing to take.

If you need income from the portfolio, you can then “create your own dividend” by selling a portion of your holdings. For example, if your portfolio happens to only produces $1,000 of income but you need $3,000, you can simply sell $2,000 of your holdings to meet your income needs (of course your calculations need to account for how much you’ll owe the government, since interest income, dividend income, and capital gains are all taxed).

With this approach you can maintain a better-diversified portfolio: focusing on hitting a specific income target can result in a portfolio too heavily weighted toward bonds or too heavily weighted toward stock sectors (such as Utilities and Consumer Staples) that tend to pay higher dividends. By thinking about the total return rather than a specific income target, you don’t have to worry about your income needs skewing your portfolio.

The Danger of Company Stock in 401(k) Accounts

Enron

When you’re thinking about how to select investments in your 401(k) account, there are often many options to choose from. Most of these are diversified mutual funds that each contain hundreds or thousands of stocks or bonds (or sometimes both). Many companies, however, also include a much less diversified investment option in their 401(k) plans: stock in the company itself. It’s an investment option that’s best avoided.

Lots of people (though certainly not everyone) like company they work for, so it may feel good to invest in your employer. This can be especially true when the company is doing well, since both the price of the stock and your income from your job are more likely to rise. But if the company starts doing poorly, the stock price and your income could decline at the same time, hurting both your paycheck and your portfolio. In other words, owning stock in the company you work for reduces the diversification of your wealth.

A classic example of this situation was Enron, the energy company that went bankrupt in 2001. Enron employees held nearly 60% of their retirement assets in company stock, which was wiped out as the company collapsed. Thousands of employees, many unaware of the risk they were taking, lost both their job and their retirement savings.

Enron is an extreme example: few companies will collapse in such spectacular fashion, and only having a small portion of your 401(k) in company stock isn’t likely to devastate your portfolio. Still, as a rule of thumb, it’s better to avoid such concentrated investments, especially when their performance may be connected to your income from your job.

Different Countries, Different Sectors

Map

US and international stocks often perform differently, which is why the result of owning both is usually a better-diversified portfolio. There are many reasons for these performance disparities, such as different economic conditions, different laws and regulations, and different effects from currency movements. Yet there’s another key difference that’s often overlooked: US and international stock markets tend to be made up of very different types of companies.

Led by companies such as Apple, Google, Microsoft, technology is the biggest sector in the S&P 500 index of large US stocks. Since there are fewer large technology companies based in foreign countries, however, technology is one of the smaller sectors among international stocks. In the other direction, the financials and materials sectors are much better represented among international stocks than among US stocks.

For individual countries, the differences with the US can get even more extreme. About half of Russia’s stock market is comprised of energy companies, compared to less than 10% in the US. And many emerging markets, including Brazil, China, and Russia, have almost no companies in the health care sector.

As a result of these differing sector breakdowns, factors that help or hurt a specific sector can disproportionately affect the performance of stock markets in some countries. When deciding how to invest internationally, understanding the implications for the sector exposures of your portfolio is an important consideration.