September 18, 2022

A Case for a Truly Diversified Portfolio | Part 3

#3 The US Stock Market is, to a Global Market, like what an individual stock is to an index fund.

With regard to two things: It is risky (relatively). And it’s placing a bet.

Owning just the US Total Stock Market (or being heavily concentrated in it), is placing a bet, however implicit, that your portfolio will outperform a global standard. That the US Stock Market is the sure thing. That it will always be the stock market winner in the next 10, 30, 100 years.

The creation of the Index Fund is based largely on 2 things that posed a significant handicap for investors. One is with the issue regarding high fees* and second is the well-proven fact that stock/fund picking, even for the professional investor, is a difficult game.

It turns out that on average, only a minority of people end up beating the market (the index/benchmark), and those minority that outperformed the market return this year, are not going to be the same set of people who will end up beating the market in the next few years. It’s difficult to beat the market, close to impossible to do it consistently. You’d have to be up there with Buffett and Munger.

The takeaway is instead of placing bets on which stocks will do well, spending an immense amount of time and energy and worry, only to end up with a high probability of underperforming the market, you simply buy and own the whole US stock market. That’s it. And you’ll even come out ahead. You don’t try to beat the market, you join it.

Now, here’s my question: why stop there?

The US stock market is only one of 40+ investable country stock markets. And even the Global Stock Market as whole is only one out of the 3 major asset classes you can invest in: 1) Stocks, 2) Bonds, and 3) Real Assets.

The US Stock Market fund is one fund in the whole slew of investable assets in the world. Owning just that is comparable to owning just a handful of individual stocks in the grand marketplace of investing. It is placing a bet that the US will beat all other markets, and beat them consistently. Do you see the irony here? Don’t try to beat the global market, join it.

The rise of the US empire in the past century was a boon to the US market. Capital poured in. But out of the 12 decades from 1900 to the 2010s, how many times do you think the US market emerged as the winner against a diversified global mix of stock markets?

“The table below looks decade by decade at how equity performance across countries stacks up.”

Answer: 4 out of 12 decades.

Even with the rise of the US as a global leader and superpower after World War II, a diversified global mix of stock markets still beat the US stock market in 8 out of 12 decades.

“The [global mix] equally weighted stock portfolio took material losses at times, but experienced drawdowns that were shorter and shallower, and it tended to recover faster than most individual country equity markets.” – Bridgewater

And that’s really what we want when we diversify, right? To reduce the risk of severe and prolonged drawdowns. Especially if you’re close to retirement or are in your retirement.

As a good rule of thumb: “In determining how much to allocate between domestic and international equities, a helpful starting point for investors is global market-capitalization weight” – Vanguard

Having a global market-capitalization weight simply means your stock portion reflects the relative sizes of world stock markets. (pie chart on the right shows the current global market-cap weight, pie chart on the left shows what it was 120 years ago at the start of 1900).

I’d like to emphasize that this is merely a good rule of thumb, and a “starting point.” But for most of us, this starting point is actually good enough. Vanguard’s current recommendation is 60% US and 40% international; this is what most of their stock allocations for their global funds look like.

For us non-professional individual investors, trying to buy individual country stock markets might be too much work. And we might end up spending too much time and energy worrying about it all, and get too deep into the rabbit hole. We don’t want that. After all, We’re pursuing Financial Independence so we can focus on other, more important things, right?

Luckily for us, dividing the world stock markets into three regions is good enough. It can be divided into other, more specific ways, but for me, this would be the simplest way to go about it:

US Stock Market
Developed Markets – consisting of mostly Europe, Pacific/Japan, and Canada
Emerging Markets – Current top three countries are China, Taiwan, India

Vanguard’s ETFs for those three are the following, respectively: VTI, VEA, VWO. Other companies have them as well. As far as with implementing a good mix of those in the stock portion of your portfolio, again, a good starting point would be market-cap weighted: about 60% US, 30% Developed Markets, and 10% Emerging Markets. There are also ETFs that are “Total World Stock” index funds. In a single ETF, you get a global mix of stock markets set at the current market-cap weight. For Vanguard, the ticker symbol is VT. That might be the simplest way to go about it.

“OK. But wouldn’t adding international stocks be just adding more risk?”

This is true and on the surface makes a lot of sense BUT. It’s not necessarily adding more risk. It’s merely adding a different kind of risk, as you subtract the kind of risk that comes with a US market. By allocating some of your stock portion to international markets, you are on the flipside decreasing your US allocation, and thereby decreasing your concentration of US-risk. You are spreading your risks, not chasing returns. And isn’t that the essence of diversification anyway?

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*The issue of high fees paid to active fund managers is now largely a thing of the past. If your net expense ratio is 0.30% or greater for a portfolio of mostly passive index funds, you should look into that. Generally, the standard now should be 0.10% or less. For Robo-advisors, I think the current average is around 0.25%; for the services they provide, I think that’s not bad.

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