June 1, 2018

Going Global: The Importance of Global Diversification

For U.S. investors thirty years ago, diversification was as simple as making sure your portfolio combined both stocks and bonds, with some variety in the sizes of the companies in which you invested. But we have all seen how much the world has changed since that time. One of the most significant changes for investors is gaining access to the economic opportunities outside of the United States.

Globalization has made us much more aware of economic growth and investment opportunities around the world. The United States only accounts for about 25% of global Gross World Product (GWP),1 and only 52% of the global market capitalization of all stocks.2 And after adjusting for currency differences, advanced economies only represent about 42% of global GDP.3 This means that many of the opportunities to capture economic growth lie outside of this country, and even outside the developed world.

Arnerich Massena started building global portfolios in 1995, recognizing the prospects of global growth, as well as the diversification advantages of investing outside of the United States. Now, watching the demographic shifts that are taking place, global diversification is becoming even more important. We see two main reasons why building a global portfolio that includes both international and emerging markets is important for investors.

Demographic Shifts

In developed nations, populations are aging and birthrates are lowering – a recipe for slower economic growth. But developing and emerging countries are experiencing tremendous population growth, as well as an expansion of their middle class, as those countries become more prosperous and productive. GDP growth in developed economies in 2017 averaged 2.2%, whereas developing countries showed GDP growth of 4.3%, and the least developed countries 4.8%.4

The image below illustrates Demographic Transition theory, which posits that pre-industrial countries start out with high birth rates and high death rates. As they become more industrialized, death rates decrease due to improved public health, while birth rates also decrease as people have access to improved birth control and choose to focus on economic production rather than building large families. Developed countries like the U.S., European countries, and Japan, would be placed into Stage 4 of this model, whereas emerging countries look more like Stage 2, with a declining death rate but continuing high birth rate, resulting in the working age, productive segment of the population being larger.

Source: OurWorldinData.org

Diversification Value

Over long periods of time, returns from international stocks and domestic stocks tend to be fairly similar. The correlation between U.S. equity (as represented by the S&P 500 Index) and international stocks (MSCI EAFE Index) over the past ten years is quite high at 0.90 (1.0 would be perfect correlation). But that doesn’t mean international stocks don’t add diversification value; short-term correlations between U.S. and international stocks vary considerably. The chart below illustrates how much correlation between U.S. and international has changed year-over-year over the last ten years, demonstrating the diversification benefits of including international and emerging markets stocks.

Why is correlation important?

Correlation refers to how close the return patterns are of different types of investments. The closer the correlation is to 1.0 between investments, the more similar their returns are. Investments that are not highly correlated provide the most diversification benefits, as they aren’t likely to move in tandem with one another.

U.S. Equity: S&P 500, International Equity: MSCI EAFE, Emerging Markets: MSCI EM

Source: Morningstar Direct, based on 12 monthly observations

Diversification is not just about returns, though – it is also about mitigating risk. Keep in mind that by including international and emerging markets stocks, you are also diversifying your exposure to political and currency risks.

It’s natural for investors to have home bias – that is, a preference in favor of domestic investments. Investing within the U.S. is likely to be more familiar and comfortable. But getting out of your comfort zone to diversify globally can be good for your portfolio.

 

1 MSCI ACWI

2 “Asset Allocation guide: U.S. vs. international equity” by Larry Swedroe; March 4, 2014; https://www.cbsnews.com/news/asset-allocation-guide-us-vs-international-equity/

3 “GDP Share of World Total (PPP) Data for All Countries,” Economy Watch; http://economywatch.com/economic-statistics/economic-indicators/GDP_Share_of_World_Total_PPP/

4 “World economy,” Wikipedia; https://en.wikipedia.org/wiki/World_economy