Nobel Prize winner in economics Harry Markowitz famously said diversification is the only free lunch in finance. What he means is that in academic terms, diversifying tends to lower portfolio risk without reducing expected returns. That doesn’t mean that concentrated positions can’t pay off — just that the risks of being undiversified aren’t worth the chance of getting lucky.
One of the more controversial aspects of diversification in recent years has been international vs. US equity exposure. Home bias is a well-documented phenomenon where people tend to invest in their own country’s markets more than others. Experts used to think part of the reason was the difficulty in accessing other markets, but these days it’s pretty easy to get international exposure. Yet many investors still prefer to invest domestically.
The last ten years have been great for US markets, while the rest of the world has lagged a bit, performance-wise. Though that might lead some investors to say, “Hey, maybe a little home bias isn’t so bad,” there’s no guarantee US markets will continue to be as strong in the future compared to other markets. In fact, eventual reversion to the mean is likely at some point.
For years, Telarray has maintained a hard line about meaningful international diversification. We’ve even parted ways with clients because we were unwilling to compromise on this matter. That said, after a lot of internal discussion, we’ve decided to offer two new sets of portfolios, one with international exposure cut in half (“international light”) and one domestic-only.
If you ask us if these portfolios are right for you, we’re going to tell you probably not. They’re only for a tiny handful of clients with staunch emotional aversion to investing internationally. We do believe it’s possible to meet long-term financial goals with reduced international exposure, but as Harry Markowitz would say, it comes with increased risk but not increased expected returns. We’re doing this because we believe a good investment program you can stick with is better than a great one you can’t stomach and eventually take to all cash (or worse).
There are times — like the recent past — where a US-only allocation results in better returns. However, the risk is not always obvious in return numbers that just represent one of many possible outcomes. Here are a few points that argue against a US-only investing approach and reinforce the value of our global portfolios:
- One of the reasons recent years have been so great in US markets is the unprecedented fiscal and monetary support we’ve experienced. The support has undoubtedly benefitted domestic investors up to this point. Nobody knows the future, but it seems that this extreme level of support cannot continue forever.
- One of the reasons Congress and the Fed could provide this support is the hegemony of the US dollar as a world reserve currency. The dollar isn’t going anywhere anytime soon, but there are other alternatives nipping at the dollar’s heels and one might get traction eventually. China’s Belt and Road initiatives will undoubtedly increase international trade in the Yuan. There are new proposals every year to modify the petrodollar system to limit the dollar’s role. Cryptocurrency (everyone’s favorite innovation to love or hate) might someday become a real alternative to state-supported money. We wouldn’t bet against the dollar yet, but we also wouldn’t be surprised if its dominance wanes in coming years. International diversification is wise in such an evolving world, even if the dollar ends up being just as dominant in 2121 as it is today.
- Probably the single biggest reason to diversify out of a single country (even a big one like the US) is the possibility of the unexpected. Something big and dramatic, like a big earthquake from the New Madrid fault, a sustained outage of power grids or pipelines (like the recent pipeline hack but worse), or a dirty bomb in a major city could seriously impair any single country’s economy, including the US. Broad diversification is the one way to potentially reduce the impact of the next black swan, which by definition cannot be predicted.
Despite these risks, there’s a lot of life left in the United States. We can’t predict whether the US or non-US stocks would outperform in the next ten years — it’s absolutely unknowable. The great thing is, we don’t have to choose. Global Telarray portfolios contain approximately a 60/40 mix of US/non-US stocks, which align with the actual global ratio of market sizes. Through the magic of rebalancing, Telarray portfolios will be buying low and selling high across the board, in a relative sense, as time goes on.
These new portfolios have been discussed for some time, and we’re happy to expand the menu of choices for our investors. However, our global Telarray portfolios will continue to be the cornerstone of our investment offerings and the default for new implementations. In the future, we hope to continue to innovate and offer new investing opportunities, including ones we can wholeheartedly endorse.