Harry Markowitz, the creator of modern portfolio theory and recipient of a Nobel prize for economics, once described diversification as “the only free lunch in finance”. However, research recently published by Bridgewater Associates, the hedge fund often lauded as the most profitable ever, suggests that too many investors still don’t believe in a free lunch.
You could arguably leave Melissa Saphier, Karen Karniol-Tambour and Pat Margolis’ paper, Geographic diversification can be a lifesaver, yet most portfolios are highly geographically concentrated, after reading the title and still get much of the value. Those unwilling to take the assertion on faith, however, will be rewarded with a comprehensive and convincing, yet brief argument.
The premise that underlines the report is one that will be familiar to many investors. Namely, avoiding losses is a hugely important part of making investment gains. As the authors put it: “The best way we know to earn consistent returns... is to build portfolios that are as resilient as possible to the range of ways the world could unfold”. They go on to note that having investments too focused on one area is a common weakness. Put simply: “There have been many times when investors concentrated in one country saw their wealth wiped out by geopolitical upheavals, debt crises, monetary reforms, or the bursting of bubbles, while markets in other countries remained resilient.”
The United States, for example, which has been the best-performing country in the current decade with 182 per cent excess equity returns, was among the worst performing in the prior decade, with losses of 27 per cent after the bear market book-ends of the dotcom bubble burst and the financial crisis.
Even in the absence of some major upheaval, performance tends to diverge widely across the best- and worst-performing countries in any given period, so it is usually a better idea to have as diversified a portfolio as possible, similar to how one might choose to buy the index rather than attempt to pick winning companies. Geographically diversified portfolios minimise drawdowns, making for more consistent returns and, by extension, faster compounding.
Bouncing back
The authors do not argue that a diversified portfolio is infallible, simply that when it runs into trouble, it suffers smaller losses and recovers quicker. To illustrate this, the authors looked at various equity markets at their period of worst drawdown, taking, for example, France’s performance during World War II, or Taiwan’s during the Asian Financial Crisis. The equal-weight portfolio’s losses of 61 per cent – during the great depression – were less than those suffered by all but one country. Switzerland saw losses of 51 per cent during the global financial crisis, although by comparison, the equal-weight portfolio lost 49 per cent over the same period.
“The equal-weighted portfolio took material losses at times but experienced drawdowns that were shorter and shallower, and it tended to recover faster than most individual country equity markets,” the authors noted.
Broad exposure is becoming more and more important
The benefits of diversification may have been more difficult to recognise in recent years, the report notes, as increasing globalisation has led to “unprecedented high correlations” in the postwar era. However, this may be on the wane, and the authors note alarmingly that “in the past, there have been ebbs and flows in the pace of globalisation – including a period of rising trade tensions culminating in the world wars – and of course we see rising anti-globalisation sentiment resurging today”.
Rising protectionism is likely to lead to increasing divergence across countries, as is the rise of China. The report argues that given China’s “divergent secular conditions” – its increased ability to stimulate its economy in a downturn – “raises the likelihood of an increasingly multipolar and less-correlated world”.
What’s more, investors still have vanishingly small exposures to China. Even as its share of global output climbs towards 25 per cent and its share of global assets approaches 10 per cent, China’s share of foreign portfolios has remained stubbornly below 2.5 per cent. This is in spite of the fact that with the CIBM bond market opening in 2015 and the Shenzhen Stock Connect opening in 2016, Chinese markets are now largely accessible to investors at this point. Similarly, emerging markets remain underrepresented in investors' portfolios.
Bridgewater attributes this to a strong home country bias on the part of many developed world investors, a bias they can ill-afford in the current climate. They must diversify to reduce their risks. As countries around the world grow more insular, individuals must go in the opposite direction.
