By: Frank Armstrong
By: Frank Armstrong, CFP, AIFA
Last year brought globally diversified investors solid but uninspiring results. For the third year in a row, global asset allocation under-performed a domestic-only portfolio. So, it’s important to examine once again the rationale for international investing. After all, an appropriate investment strategy should be driven by more than just perverse stubbornness. I hope that you will conclude that it is still an appropriate model for prudent investment of your hard-earned dollars.
The objective of global diversification is to produce liberal returns over time while taking the very minimum possible risk to generate them. A rational investor should be obsessed with producing satisfactory returns with minimum cost, minimum risk techniques.
The overall strategy is really very simple. It consists of two parts: a bond strategy and an equity strategy.
The bond strategy is designed to provide either a store of value to fund known future disbursements, or to reduce portfolio risk to a tolerable level for risk averse investors. A short-term, domestic-only, high quality bond funds should generate a liberal positive return with minimum risk.
The equity strategy divides the world’s stock markets into nine broad asset classes, four domestic and five international. Over a long period of time, eight of the asset classes have outperformed the S&P 500, while the ninth is the S&P 500! Some of the asset classes have outperformed the S&P 500 by more than 10% average compounded per year. As you can imagine, these asset classes carry additional risk. Yet, when we mix these asset classes together, because they have low correlations to one another, the resulting risk at the portfolio level is not substantially higher than the S&P 500. There is strong economic reason to believe that these asset classes will continue to generate excess returns, and there is no evidence to support the conclusion that correlations are increasing.
Each asset class has had periods of under and over performance. That’s what low correlation means. There is a distinct pattern to this performance. Small companies have higher performance than large. Note the high number of five-year periods where the top performing asset class was international small during the period 1970 to 1996. Domestic small companies usually perform better when domestic large companies outperform foreign, and the reverse is also true. When foreign large companies outperform ours, the foreign small companies usually have even better relative performance. There is every reason to believe that this pattern will continue.