The conventional wisdom says you should diversify your portfolio around the globe. Right now, though, that looks like a sucker’s bet.
Do you really want to put your savings into continental Europe while war is raging in Ukraine? Or in Britain, which is still struggling to figure out how to make Brexit work two years after the deal was supposedly completed?
China, too, is looking like a riskier bet than we once thought. Growth in the Asian giant has ground to a near-halt in recent months because of Beijing’s insistence on locking down major cities to prevent the spread of COVID-19. There is no telling what will come next. After all, the country’s leaders just spent the past two years gutting the country’s online giants. More politburo temper tantrums could be on the way.
What about emerging markets in general? They’ve taken a horrific beating over the past year. Maybe that spells opportunity. Just as likely, though, it means more problems ahead as interest rates rise and global growth slows.
It all adds up to an ugly outlook for the conventional wisdom about international diversification. And since I’ve spent years practising that supposed wisdom in my own portfolio, I’ve recently been reassessing the case for venturing abroad.
The part of the international diversification story that still makes sense to me is the acknowledgement that none of us can foresee the future. Look at the course of major markets over the past 20 years and the only clear takeaway is that different regions bloom at different times, often for unexpected reasons.
Consider the 2002 to 2008 period. It was the best of times for China, which joined the World Trade Organization in 2001 and promptly took off on an export-fuelled economic growth spurt that surprised even the giddiest optimists. Resource-rich Canada was a major beneficiary of China’s warp-speed growth as Asian demand for natural resources sent commodity prices spiralling higher.
Sadly, those happy times ended with the global financial crisis in 2008. After quadrupling between 2002 and 2008, the MSCI China Index spent the next decade going essentially nowhere. Similarly, Canada’s S&P/TSX Composite index nearly doubled between 2002 and 2008, then made no lasting headway over the following 10 years.
In their place, U.S. stocks – especially tech stocks – took centre stage. After a miserable 2000 to 2008 patch, marked by the lingering effects of the dot-com mania and a gigantic real estate bubble, Wall Street surprised everyone in the wake of the financial crisis by turning around and dominating the following years – until this year that is when it, too, suffered painful losses.
Nobody, to the best of my knowledge, consistently called each of these twists and turns before they happened. This lack of foresight remains the strongest reason for international diversification. None of us can predict which region will thrive over the next few years, so it makes sense to own a bit of each.
But how much and when? The weakest part of the usual international diversification story is its insistence that you should buy a market simply because it is cheap.
That reasoning simply hasn’t worked out in practice. Japanese stocks and European stocks have frequently looked to be bargains in recent decades, yet neither has delivered outstanding returns.
Valuation matters, no doubt, but what seems to matter even more is an economic catalyst. It could be an export boom, a technological shift or a resource boom, but countries need something to put their stock markets into high gear. Otherwise, they wind up like Japan or Europe – homes of perennially cheap stocks that typically produce ho-hum returns for investors.
So what can investors do? One idea I’ve been experimenting with is trend following. Spot a region that is booming, then jump on board.
To test this idea, I went back to 2009 and looked at what would have happened if you had invested in the hottest region of the previous year. I used the MSCI indexes for the U.S., Canada, Europe, Japan and emerging markets as my investing options. Then, each year, I assumed I invested all my money in the region that had done best the preceding year. (I calculated all returns in U.S. dollars to put the regions on a more or less equivalent basis.)
My simple-minded strategy would have produced an average annual return of 10.8 per cent between the start of 2009 and the end of 2021. Was this good? It was nowhere near the 16-per-cent annual average returns that someone who invested in the U.S. market would have achieved over the same period.
On the other hand, it was substantially better than the buy-and-hold results that would have been achieved by someone who stuck to any one of the Canadian, European, Japanese or emerging-markets indexes. It was also slightly ahead of the results that would have been achieved by simply buying the MSCI World Index, spanning all these regions.
I’m not sure if this qualifies as a triumph. Among other issues, my strategy ignores the potential tax consequences of shuffling your portfolio every year. It is also based on a small slice of history.
However, it does suggest that there is something to be said for taking the conventional wisdom about international diversification with a grain of salt. Right now, based upon the past 12 months, the strategy would propose sticking close to home, in Canadian stocks. That seems rather sensible.
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Ian McGugan