When I was growing up we were obsessed with backyard cricket, which was a bit hairy because the back of our house had a door with a very large glass window pane.
Well, you can guess what happened.
I’d have liked to explain to my old man that if there’d been lots of smaller window panes instead of one large one the repair bill would’ve been cheaper, but funnily enough he wasn’t in the mood for that conversation…
Eggs in multiple baskets
Diversification is one of the most resounding mantras of investing, and most of us like to hold a balance of uncorrelated assets, including property, Aussie stocks, international stocks, and cash.
Diversification can help to minimise the risk of loss, and preserve capital, and it can help to generate returns by giving you exposure to multiple investments.
There are a number of ways to diversify within stocks, including holding a range of separate investments, investing in products which are themselves diversified (such as country or sector ETFs), and diversifying over time by staging your entry to an investment (because even a cheap investment can always get cheaper).
The home bias
Most people like to invest in assets that are close to home, both for property and stocks.
There’s some psychological comfort in being able to drive past a tangible real estate investment.
But given Aussie stocks might make up just 2-3% of global indices, it’s not so rational that we invest so heavily in our home index.
To be fair, over the past 120 years the Aussie stock market has been one of the strongest performers, but in reality that kind of timeframe is irrelevant to any individual investor, and it’s future returns that we’re interested in.
Thus when local stock market returns look set to be low, it makes sense to consider international markets.
The old assumption was that the stock markets of countries around the world were not closely correlated at all.
But the world has become more interconnected since the 1980s, and the global financial crisis showed that international markets may be more closely correlated than was previously thought.
When the poop hits the fan everything correlates to one, as the saying goes!
There’s a growing need, then, to pay attention to how well diversified you are in your stock portfolio.
If you look at a ‘quilt’ of returns from developed markets, you’ll notice that they do tend to move together to a certain extent, even if the annual returns differ.
Given that the US might account for around half of the value of global stock indices by market capitalisation, it’s unrealistic to expect that a crash in the US wouldn’t impact all other markets (and Australia isn’t immune, as we saw when our market crashed in 2008).
Diversification in practice
Yes, there’s still a correlation between markets, but generally, the CAPE ratio shows that countries (and indeed individual stocks) that are already cheap do not fall as much as their higher priced compatriots.
In a globalised world it’s critical to watch what is happening in – and the valuation of – the US market.
It’s folly to believe that a whale of a market will not impact the large number of minnows.
When the US is expensive (as it is of the time of writing), it’s prudent to reduce your exposure to markets that may be more expensive than their average CAPE ratio.
You should not, however, avoid all investing because the US is expensive.
If you invest in overseas markets by taking a long-term approach, you can, for example, purchase large-cap systemic type stocks that pay a reasonable dividend, or you can focus on ETFs and diversify across countries, sectors, and styles that are cheap.
Combined with the principles of asset allocation and rebalancing, we can succeed in generating solid returns in a low interest rate environment, even while the US market is expensive.
When the next US correction comes around, it will bring other developed markets down with it, and you will have some dry powder (cash!) to capitalise on the wonderful opportunities that such corrections always bring.
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