Harry Markowitz published a paper in 1952 that changed investing. His theory was that investors want the highest return possible for the risk taken. Modern portfolio theory (MPT) was born, and Markowitz won a Noble Prize for it. MPT states it is possible to mix assets to create the most efficient portfolio. The most efficient portfolio is the one that earns the highest return per unit of risk. Volatility is the measure of risk used. The most efficient portfolio is the one that earns the highest risk-adjusted return. An investment’s risk and return characteristics should not be viewed alone. Instead, the investment is worthwhile if it increases the portfolio's risk-adjusted return.

Diversification creates more efficient portfolios. Diversification among asset classes and within asset classes can increase risk-adjusted returns. It works because assets are not perfectly correlated. Asset classes and investments within asset classes do not all move in the same direction, at the same time, and in the same amount. In one year, U.S. stocks might outperform international stocks. The next year international stocks might outperform U.S. stocks. Bonds might outperform stocks in any given year. There are several 20-year periods where bonds outperformed stocks in the United States. Emerging markets have had extended periods of outperformance as well. 

Diversification is often called the only free lunch in investing. It is a free lunch because it is possible to increase your return without increasing your risk. Except it does not work over the short-term. Correlations move higher when markets are under stress. Market panics spill into other markets. Investors sell whatever they can to reduce risk. The recent sell off in the U.S. saw stocks, bonds, and gold all sell off together. The same happened during the Great Recession. 

Diversification does work over the long run though. The data is conclusive. An investor with a time horizon of decades benefits from diversification. Returns depend on economic growth and interest rates in the long run. Bonds have outperformed stocks at times in the past, so have international assets. Emerging markets outperformed the U.S. market by almost 300% from 2002-11 for instance.

Yet, most investors still weight portfolios to home country securities. It is called home bias. The U.S. economy is between 20% and 25% of the world economy. The U.S. stock market accounts for around 45% of total world stock market capitalization. Yet, the average American investor is overweight U.S. stocks. The average exposure to international assets is around 15%. U.S. investors are underexposed to the rest of the world. Emerging market economic growth is historically double to triple the U.S. growth rate. Emerging market stocks are likely to outperform U.S. stocks over the next 10 years. Investors would do well to avail themselves of the free lunch.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist