Insights

An investment operation is a business of dealing with uncertainty. What makes it much more turbulent is that financial markets cycle through periods of low volatility (low realized uncertainty) and high volatility (high realized uncertainty).

As we discussed in The Biased History that Drives Excess Allocations to Equities [1], The distribution of investment returns from equities has a moderately negatively skewed profile. What that means is that there are many more and significantly larger losses than is predicted by standard risk metrics like standard deviation. As we stated, “Every period of a lasting bull market gives rise to the idea that it is different this time. The reason why we end up with this idea in each cycle is driven by another attribute of skewed distributions – it takes considerably longer to appropriately assess the true properties of a skewed distribution than is the case with a normal distribution [2].”

Quantification of risk by looking in the rear-view mirror: Underestimation of volatility

When financial markets have gone through a prolonged period of low volatility, it is easy to feel highly certain about the future and to have high confidence in one’s abilities to handicap future outcomes. Naturally, assessments of the range of outcomes at this point in the cycle tend to be much narrower than they ought to be. The result is that portfolios end up being too concentrated.

It is only to be expected that diversification is detested during such periods. Clearly, when the range of outcomes has been narrow, you do not get any benefit from diversifying your portfolio. Indeed, diversification during such periods exacts a cost, especially compared to asset classes that have performed the best.

It isn’t surprising then that global diversification stands on a thin wicket post such a period. An important issue also is that during periods of stress/crashes like the one we experienced in March 2020, correlations tend to increase towards one as nearly all markets crash together.

So the question then is, why diversify globally? Is there any benefit at all from diversifying a portfolio globally?

Global diversification: Improving the chances of earning that promised equity return

Well, the answer to that question depends on one’s investment time horizons. As discussed in Realistic Assessment of Long Run Investment Returns, there is a significantly wide variation in investment returns for various countries, even within the advanced economies and even when looked at very long periods extending up to 150 years. Indeed, the annualized real total returns across 16 developed countries over the last 100-plus years have ranged between 0.8% to 7.2%. As we stated, “U.S. stocks were one of the best performing markets of the past 150 years and investors who maximized their U.S. allocations would have benefited from such decisions. However, as investors, we cannot eat past returns. If you have perfect foresight as to which county will have the best performing market for the next 100 years, it will likely make sense to direct much of your equity investment to that country. For those of us who do not have that foresight, the most rational course of action is to invest in globally diversified equity portfolios.”

When you look at returns realized by investors in different countries, it has made sense to construct a global portfolio as against being concentrated in your home country. Below, we have reproduced a chart of investment performance of U.S. equities and Global equities from the perspective of a U.S. domestic investor. Further, the chart that follows shows the performance of Indian equities and Global equities from the perspective of an Indian domestic investor. In the appendix, we included charts for all countries included in our study, including India.

While the U.S. equity markets were one of the strongest performers over the past 150 years, bested only by Australia, the global portfolio’s return got very close to the U.S. equity market’s performance. Indeed, the global portfolio was significantly superior to most individual country portfolios.

U.S. Domestic Investor’s returns: U.S. domestic portfolio and global portfolio, inflation-adjusted total returns.

Indian Domestic Investor’s returns: India domestic portfolio and global portfolio, inflation-adjusted total returns

The data suggests that constructing global portfolios improves the chances of one earning the “promised” long-term equity market returns. So from the point of view of returns, it makes sense to diversify globally. But how about risk? Do globally diversified portfolios result in lower risk? Do they help the Investor better weather the long drawn-out bear markets? To that end, we examined the benefits of global diversification over long holding periods [1].

Data

The data for our work was sourced from IMF, OECD, Factset, and Jorda-Schularick-Taylor Macrohistory database. In most cases, rates of return from 1870 to 2015 have been sourced from Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor. 2019. “The Rate of Return on Everything, 1870–2015.” Quarterly Journal of Economics. Forthcoming. Data after that is sourced from IMF, OECD, and Factset.

To analyze the benefits of global diversification, we looked at investment returns from the perspective of local investors in 16 advanced economies and that of Indian investors. The countries and the data periods included Australia (1871-2021), Belgium (1871-2021), Denmark (1875-2021), Finland (1896-2021), France (1875-2021), Germany (1875-2021), India (1962-2021), Italy (1875-2021), Japan (1886-2021), Netherlands (1900-2021), Norway (1881-2021), Portugal (1875-2021), Spain (1900-2021), Sweden (1875-2021), Switzerland (1900-2021), U.K. (1875-2021), and USA (1875-2021).

Domestic and Global Portfolios

We used local currency-denominated total returns data, inflation data, and foreign exchange rates from the data sources referenced above for the various periods.

Domestic Portfolio. The domestic portfolio represents the Investor’s home country portfolio. We calculated the total return of the portfolio adjusted for inflation, i.e., real returns.

Global Portfolio. The global portfolio represents the return from investing globally, including in the domestic market. For our analysis, we have used an equal-weighted global portfolio. The domestic investors’ total returns from the global portfolio were calculated by converting the total returns of other countries to the investors’ home currency returns using the exchange rates between the Investor’s home country and other countries. We then backed out the local inflation to calculate the real return from the global portfolio in the hands of the domestic Investor. It is important to note that the returns so calculated will be different for investors in different countries as they will be affected by the exchange rate and inflation differences among various countries.

Long-horizon outcomes: Superior outcomes during turbulent times

To test for the benefits of global diversification during periods of poor outcomes, we looked at the investment return to the domestic portfolios over varying investment horizons spanning over holding periods of one to ten years. We created the domestic and global portfolios for each of the 16 countries and averaged the outcomes across countries.

The chart below shows the worst outcomes for the domestic portfolios over one-year to ten-year holding periods. The vital thing to note here is how long the bad outcomes can persist. The gold line shows the performance of the global portfolio during those same periods. As is seen, much as the domestic portfolio’s large declines during a one-year holding period, the global portfolio also generates a large negative return, albeit somewhat better. It is over holding periods extending beyond three years that the global portfolio’s risk diversification’s benefits come to the fore. During periods of prolonged domestic bear markets, the global portfolio generates much superior risk outcomes.

As against looking at THE worst outcome, the chart below looks at the average of the worst-five outcomes over varying holding periods and the global portfolio’s outcomes over those same periods. Again, we can see that global portfolios report similarly large declines over short time horizons. However, as we extend the time horizon to 3+ years, the globally diversified portfolio’s outcomes during periods of poor domestic outcomes end up significantly superior.

Summary

Over short horizons, global diversification doesn’t offer significant benefits as markets do tend to crash together. However, it does an excellent job of protecting investors against the deep and painfully long draw-downs experienced during prolonged bear markets. As the authors in the article referenced earlier stated, “Investors whose planning horizon is measured in decades should not be overanxious about the risk of common, short-term crashes. Instead, they should care more about long, drawn out bear markets, which can be significantly more damaging to their wealth.”

————————————————

[1] https://www.advisorperspectives.com/articles/2020/07/27/the-biased-history-that-drives-excess-allocations-to-equities

[2] Sometimes you will hear that if we have 30 observations or more, we have a reasonable sample size. For one, there is nothing magical about that number 30. Such generic advice should at best be ignored. However, when applied to distributions like investment returns, it may prove to be grossly inadequate.

[3] This part of our study is inspired by the an article published in the Financial Analysts Journal – International Diversification Works (eventually) by Clifford S. Asness, Roni Israelov, and John M. Liew, FAJ Volume 67, Number 3

Appendix

Investment Returns: Domestic and Global Local Fx Portfolios, Inflation-Adjusted

Investment Risk: Drawdowns for Domestic and Global Local Fx Portfolios