Diversification is one of the most recommended investment strategies, yet adhering to this fundamental has caused investors a fair amount of grief over the last few years. Why???
Generally, as to not have “all your eggs in one basket”, investors will divide their nest eggs a number of ways in an effort to lower the overall portfolio risk. Common diversifiers are – international stocks ranging from Europe to China, Market Capitalization (i.e. Large companies and small companies), and Commodities (Oil, Gold, Corn, etc.).
Once an investor decides how many areas she wants to invest in, the decision then becomes – how much in each area? Most people tend to place more weight to investments within their home country. The behavioral phenomenon is called “home bias”. It is only natural for people to invest more in companies they are familiar with. You know the utility company who supplies power to your home. You pay them every month, so you can turn your lights on and cook dinner. It is much more difficult for investors to feel as comfortable investing in a company in Europe that they have never heard of.
The media also plays an important part in “home bias”. News networks provide more coverage for companies within their home country. Therefore, investors are bombarded with information about their home market, and may get little information on other markets around the world. This influences their views and expectations.
So what does all of this have to do with diversification? Within any specific period of time, markets will perform differently. Proper diversification allows the investor to participate in good performance consistently over time no matter which market is leading. In recent years, the United States has led nearly all other markets in performance as we have recovered from the crash in 2008. Other parts of the world, such as Europe and Emerging Markets, have struggled to rebound in kind. For our diversified investor, this has created a frustrating circumstance.
Diversified investors have seen their performance lag a portfolio that would only be invested in U.S. companies (ex. The S&P 500). The distinction is exacerbated for U.S. investors specifically with the “home bias” of the media. However, the U.S. has not always been the best performing market. So, it is important for all investors to remember that no area outperforms every single year. While the U.S. market has led the way in this recovery, other parts of the could perform better in the future as markets recover. And therein lies the benefits of diversification, participating in good performance while diffusing negative performance.