Why would an investor use their hard-earned money to purchase shares of companies they’ve never heard of, like small and medium sized regional enterprises, rather than owning trillion-dollar multinational companies? If the United States is home to the most profitable, highest quality corporations on Earth, why invest internationally? Treasuries don’t even keep up with inflation these days, so who would ever purchase bonds?
The shortest answer to those questions is “correlation”. Admittedly, it is a bit of an obscure word, but it boils down to this: When bonds lose value, equities tend to gain. When bonds increase in value (think falling interest rates), that usually means that equities are moving down. International and U.S. stocks move at different speeds at different times and have historically had long periods of outperformance relative to one another. U.S. companies have been on a decade-long winning streak relative to their international brethren, but nothing lasts forever.
That is, all things tend to revert to their mean. In light of the fact that we live in a global market, it is reasonable to expect that at some point either the U.S. equity market will correct and trade at a reduced premium to international stocks, or to expect that internationals will have their valuations stretch to more closely approximate U.S. stocks. In either event, there would suddenly be a period of outperformance of internationals compared to their U.S. counterparts. There are all sorts of math equations which show that diversified portfolios, combinations of investments with differing levels of correlation to one another, will deliver superior returns (relative to the risk of the underlying portfolio) over time. Most people aren’t keen on seeing the math, but if you’re interested, you can Google the Sharpe Ratio and Treynor Measure for a couple of brilliant examples.
We could go through all of the various asset classes and explain the value each of them brings to a portfolio, but we’ll focus on two key examples which explain why diversification makes dollars and sense. Many investors can have little to no exposure to “small cap” companies. Small-caps are corporations with a total equity value under $2 billion dollars. These companies are much more volatile (think “risky”) than their “mega-cap” cousins (Apple, Google, Wal-Mart, etc.), meaning that in any given year, they tend to rise and fall much more than bigger, more stable companies.
Regardless of how big those losses might be in any given year, however, small-cap indexes have consistently delivered higher annualized returns to their investors over the long-term than has the S&P 500 Index (large cap stocks). By adding a small-cap position to their large-cap portfolio, investors can increase their long-run expected rate of return disproportionate to the increased “risk” in the portfolio. For bond investors, it’s even better. Rather than owning 100% bonds, if a conservative investor adds a diversified portfolio of equities to their current bond portfolio (between 20% and 30% of their total investment) it actually REDUCES volatility and INCREASES the expected annual return. This may seem counterintuitive, but over the long-term proves true.
So remember; stay invested, stay diversified, and stay informed.