The Only Free Lunch | AWM Insights #119
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Episode Summary
“Don’t put your eggs all in one basket”
Everyone has heard this saying but are you doing it as efficiently as possible with your investments? Don’t fall in love with one single investment category because this overconcentration is an unnecessary risk.
Intelligent diversification is implemented across countries (ex: US, Developed International, Emerging Markets), asset classes (ex: stocks, bonds, real estate, alternatives), and also factors (ex: relative value, small-cap, profitability).
This diversification reduces the uncertainty of hitting the priorities that matter to you and avoids devastating outcomes that resulted from the lost decade in the US, the Japanese stock bubble, and the crash of US real estate during the Great Financial Crisis just to name a few.
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Episode Highlights
(0:44) We commonly say the only free lunch in investing is diversification but why is it a free lunch?
(1:05) Diversification is easy to misunderstand when it comes to investing in risky assets. Don’t put all your eggs in one basket seems logical but the details of how you diversify intelligently will have an enormous impact.
(1:20) Jim Cramer is commonly featured on CNBC and tells people to buy one stock from each sector of the US economy (tech, industrials, etc). This isn’t smart enough diversification.
(2:10) In public markets, there are thousands of companies within this opportunity set.
(2:55) Identifying the winners within 1000s of companies has been proven to be a loser’s game when you look at the chances of outperforming over 1, 3, and 10+ year time frames.
(3:47) Don’t fall in love with one single investment category.
(4:00) Other countries have grown faster than the US even though the US has done well.
(4:20) When building portfolios, we look at the opportunity set. We want roughly 60% of equity investments in US but the other 40% should be diversified into international developed and emerging markets.
(4:35) Home country bias is evident across the globe and it is the reality that investors tend to overweight whatever country they live relative to the market capitalization of that market in the world economy.
(5:43) The lost decade is a decade of poor returns for the S&P 500. Large cap US stocks performed terribly and didn’t make investors any money.
(6:17) Emerging markets did amazing and returned over 400% during the lost decade for US large-cap stocks.
(6:50) Country returns are difficult to predict ahead of time. US markets have been a great place to invest but other markets almost always top the US when it comes to annual returns.
(8:05) Given what happened over the last decade, international and emerging markets
(9:07) If you have an advisor that is only comfortable putting you in US stocks because it is easy to communicate, is a really lazy approach. You deserve a globally diversified portfolio.
(10:10) You deserve this kind of portfolio because it delivers a higher level of confidence in achieving your priorities. Uncertainty about meeting priorities is reduced with global diversification.
(11:10) The distinction here you are not rewarded for trying to guess the region or stock that will outperform. With smart diversification across global equity markets, you increase the chance of achieving the returns necessary to meet your future needs.
(12:25) A client asked if large-cap growth outperforms? No, it actually doesn’t. The data shows it underperforms large value over the long term.
(12:53) US real estate is very popular and many people believe it always does well. The reality is in 2019 it was in the middle of the pack, in 2020 it was in last place, and in 2021 it was in first place. There is a lot of randomness in these annual returns so you want to participate across many asset classes.
(13:20) Even the US real estate market is more than just residential real estate.
(13:30) You don’t just want the S&P 500. During the lost decade of 2000-2009 it lost 9% cumulatively over that decade. Large value companies over that time returned 48%. Emerging markets were up over 400%.
(14:31) Diversification should be done intelligently across the globe, asset classes, and within the factors discussed in last week's episode.
(14:56) You need to have an investment strategy you understand. It takes more work to understand true diversification but an advisor that has your best interest at heart will spend the time explaining why it matters.
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+ Read the Transcript
Brandon Averill (00:07): Well, everybody welcome back. We're going to continue this series here, just talking a little bit about pursuing a better investment experience. And today, we're going to talk about that free lunch, or at least that's what everybody talks about, right? Is free lunch, the free lunch and investing, and that's diversification. We've got a saying around here that we love to practice smart diversification. And Justin, since you're the smartest guy I know, this is the perfect conversation.
Brandon Averill (00:36): And so at the end of the day, I think people think about diversification and there's a lot of, I guess, mystery around it, misunderstanding. "Hey, let's buy a few stocks. Let's just make sure one's in tech. Let's make sure one's in industrials." I mean the talking head, Jim Cramer, right?
Justin Dyer (00:54): The Jim Cramer model, right?
Brandon Averill (00:55): Yeah. Just hit the button buy, buy, buy. Sell, sell, sell as long as they're spread out. Folks, that isn't smart diversification, let's just start there. But as we start to unpack this, Justin, I'd love to turn it over to you. As we start, even at the basic building blocks of building a portfolio, and we're thinking about being diversified for our clients, where do you even start?
Justin Dyer (01:21): It's a big question. Simple topic if you want to think about it in its most basic sense, right? You kind of alluded to it. Diversification is really at the end of the day, making sure you're not putting all your eggs in one basket. But when you look at the investing landscape, and again, throughout this series, I want to really underscore, we're talking primarily public markets here. And it's really important to underscore that.
Justin Dyer (01:47): The starting point is to, let's look at the opportunity set and look at the data. The opportunity set is vast. There are thousands and per thousands of companies within the various public markets around the world. Within the US, that represents roughly 60% of the opportunity set. And then kind of to, not to your direct earlier point, but you have to then ask, well, okay, should I try and pick the winners?
Justin Dyer (02:15): We've talked about that, right? Individual stock picking doesn't make any sense. Trying to identify who are going to be the winners within that vast opportunity set has been proven throughout time to be a very, very difficult proposition within the public markets. And so really at the end of the day to kind of get to the initial answer here, it's trying to participate very thoughtfully, intelligently smartly across that entire opportunity set the global market capitalization where efficient access can be had to those various marketplaces or stock markets really at the end of the day.
Brandon Averill (02:54): Yeah. And it takes something mentally. I think it's worth acknowledging. It is a little bit more difficult to wrap your head around, starting to invest in other places, places that aren't familiar to you. We're sitting here in the US. So investing here in the US, it's been a fantastic journey over the last 100 plus years, we've talked about that. It's been a huge growth opportunity. But when we talk about other investment opportunities, you shouldn't fall in love with one single investment category, right? You should start to look at things and compare and contrast. Brandon Averill (03:27): Sure, the US fantastic, this has been a great growth story over time, but there are other places that have actually grown more phenomenally. And you've missed out on those returns if you've been allocated to the US the entire time. And we're not saying that you shouldn't have a meaningful allocation. What we're saying is, the way that we approach it is that you take a look at what is the opportunity set, like you mentioned, and start there.
Brandon Averill (03:53): So that's how we start, right? We start with building portfolios, we look at it and we say, "Hey, roughly we want 60." We'll add a little bit more maybe, because we do live here, we do spend money in the US. So maybe there'll be a little bit of what we in the industry call a home bias. But at the end of the day, you don't want much more than 60% of your assets on the equity side is what we're talking about. You want to invest outside the US. And there's good reasons for that, we're going to unpack some of that. But I think another fun thing to maybe go down that you hit on is systematically predicting.
Brandon Averill (04:31): And when you start, you see all these fun charts, right? It's these periodic table charts back from science class. And probably, I don't know, was sixth, eighth grade. I probably wasn't paying attention enough. But you start to look at these things and you notice the colors are all jumbled and you can't really figure out what's going on. And there is a randomness to these returns, right? You can't really figure out what's going on. And this is both in the US. It's also outside the US, whether they're developed markets more mature economies, or if they're more of the emerging markets, right?
Justin Dyer (05:05): Right. Well, and just to put some context to it. So it's been a phenomenal 10 years or decade, let's call it, within the US markets. Prior to that, there is something called the so-called lost decade. It's very easy to forget things like that. Let's just take the year 2000. I imagine very few investors were predicting that 10 years later, the US would basically have a negative return, S&P 500.
Justin Dyer (05:34): There were parts of the market, which we've talked about, small value that actually did quite well over that period of time. But guess what? The US as a whole actually underperformed most global marketplaces. Emerging markets substantially was up over 400% over that timeframe. And so it goes back to this idea of thinking long term, being a long term investor, understanding that predicting and trying to go in and out, it just really, really is difficult.
Justin Dyer (06:05): That's where you were going, Brandon, with that periodic table, right? Where you see returns from various countries stacked up on one another and there truly is no rhyme or reason to it. I mean, there's probably a reason to it, but knowing that ahead of time is all but impossible. But really, countries jump up and down and up and down. And kind of getting back to the actual numbers, we think the US has done so well. And it has, it's been a phenomenal place to invest, but let's just go back to 2021. And guess what, US was up towards the top, but good old Austria, right there at number one.
Brandon Averill (06:44): Three time champ in the last 20 years.
Justin Dyer (06:45): Yeah, three time champ. So the good old Nordics, right? Finland also up there three times over the last, what, 15 years it looks like. So we talk about the US being such a great place to invest, or a lot of people do. And it is, it is a phenomenal place. And especially because we live here, it's from a market cap standpoint, the largest single country around. And so the vast majority of assets should be there. But so many people say, "Oh, the US is truly the best market." And really quite frankly, it's not. That doesn't mean you should go put all your money in Austria or the Finish stock market either, right?
Justin Dyer (07:24): It's understanding that there are pockets that will outperform, there are pockets that will underperform. Who knows what the next 10 years will unfold, how it will unfold here in the US? Chances are international emerging markets might very well do better given what's happened over the last decade. And it just goes back to this idea of well, smart diversification, which is what we're talking about today, but also having this long term perspective.
Brandon Averill (07:53): Yeah, no, I think it's great points. And I think reflecting even over that 20-year period, the US, they only led once. We often talk about that in meetings with new prospects or clients is, you want to put all your money in the US, well guess how many times they've actually led the charge. It was 2014, so it wasn't even 2021. And you move over to the emerging markets, for instance, the growth companies, it actually becomes even more random there.
Brandon Averill (08:20): I'm sure everybody, in 2021, January 1st, fireworks going off. And we all thought, "Yeah, let's double down on the Czech Republic this year." I don't know too many people that were making that move, but the Czechs came in and they took it away. I mean, it was a banner year in 2021 for them. We're kind of saying all this tongue in cheek, but the point is, is that you deserve to capture all of these returns. And if you've got an advisor that just is really comfortable because they can communicate to you what the S&P 500 is, et cetera. That's a lazy approach.
Brandon Averill (08:58): And you deserve better than that. You deserve a globally diversified portfolio that captures all of these returns and helps to really increase that risk adjusted return for your portfolio, for your overall financial structure. It's just something that you really should focus on.
Justin Dyer (09:16): I want to dig a little bit deeper on why we say you deserve that. It goes back to really this whole concept of protecting your priorities. And that's really our definition of success. At the end of the day, success is a client and investor meeting their priorities over whatever their timeframe is. The next 20, 30, 40, 50, 60 years maybe it's multi-generational in a lot of the cases of our clients. And why that ties into this conversation is by having broad diversification, by focusing on the data, understanding where risk and return truly come from, it gives you a higher level of confidence in meeting your priorities.
Justin Dyer (09:59): We can't predict the future with 100% certainty. We can't say the US market's going to return X% over the next 10 years, or Austria's going to do a Y%. And as I say that, I've realized Austria's not in the Nordics, but that's neither here nor there. Anyway, it gives us this level of confidence and rigor in building your portfolio and structuring it to support your priorities.
Justin Dyer (10:26): Picking individual stocks starts to diminish that. Or trying to time the market or time which country to be in starts to break down the level of confidence we have in someone's ability to meet their priorities. And that, I think that's a really, really important distinction to make here where the common practice in the industry is buying and selling stocks, trying to time the market. And really at the end of the day, that is putting your financial structure or your priorities, and meeting those priorities at risk.
Justin Dyer (11:00): There is a chance that one of those stocks or one of those countries actually does outperform, but that's generally luck. I mean, the research, the data shows that that's due to luck as opposed to skill versus structuring a portfolio based on the data, based on our understanding of where risk and return truly come from and how you're actually compensated for taking risk. And it all feeds into saying, "Okay, this is a portfolio that is backed by academic research. The data makes sense. We don't know exactly what the rates of return are going to be, but there's a very high likelihood, or a much higher likelihood that your priorities will be met if the overall portfolio is structured in the right way."
Brandon Averill (11:42): Absolutely. I think that's a great point. We've been spending a lot of time so far on talking about just being diversified globally, but there's also the case for diversification within those markets. And I don't want to kind of close out here without at least touching that. I had a conversation with a client yesterday, well, large growth has to outperform, right? And we had to unpack, no actually there are other factors that outperform over time, small companies, value companies, et cetera. And there's a randomness to all of this as well.
Brandon Averill (12:17): I think a lot of people fall in love with an asset class, but the randomness, I pulled up this example, because I thought it was very illustrative and it's US real estate. Everybody loves US real estate. If you've looked around over the past few years, it seems like it's done unbelievable. But the reality is in 2019, it was actually in the middle of the pack of returns. Then 2020, last place. 2021, first place.
Brandon Averill (12:44): There's no rhyme or reason how this actually plays out. And I think our brains obviously always anchor, or not obvious, but I think many times anchor to US residential real estate and the real estate market is broad and vast. You want to participate across the entire real estate market. You want to participate across the entire US company market. You don't want just the S&P 500.
Brandon Averill (13:08): To your earlier point, the S&P 500 in that lost decade lost 9%. 9%. When you compare and contrast that to some of the other markets or the other segments of the US market, it's absolutely staggering. If you would've just focused on large value companies during that period, you would've had a return of 48% versus -9, right? So you start to eliminate companies and really just focus in and become less diversified in these markets. And then you brought it up earlier, but you go to the emerging markets, I mean, they're up 400%, like you said.
Brandon Averill (13:47): So I just want to hammer home this point at the end of the day, that smart diversification is a broad allocation across the globe. It's a broad allocation within each of the asset classes that you're picking. And you need to do that very intelligently. We've talked about other factors, et cetera, but even if you just did that, you're going to have a much better investment experience for sure. And so, I definitely want to reiterate. This whole thing is about focusing on the things that you can actually control.
Brandon Averill (14:19): You need to establish that sound financial structure like you mentioned, Justin. That's a huge, huge part of having a better investment experience. You need to have an investment strategy that you actually understand. And we acknowledge it's a little bit more difficult to understand just because it's not commonly... The talking heads on TV aren't selling it because it's not that exciting, all those types of things. So it takes a little bit of work, but if you're listening to this, you're probably at least on the path to doing that work.
Brandon Averill (14:47): You want to make sure that those investments are tax aware and low cost. That's also going to be key in this. But then ultimately what we've been talking about today, you've got to practice smart diversification. So, next week, we're going to jump into a little bit of a shift and continue down this path. It's going to be about managing your emotions. Probably not a bad time to be talking about that. We're recording this. Currently, the markets are off pretty substantially for the year. A lot of emotions flying around, "How do we do that?"
Brandon Averill (15:16): We're going to get into, one of the best ways to do that is with your financial structure, really understanding what your priorities are in building your portfolio so you can weather storms like this, and you don't have to get emotional. You don't have to be freaking out. You can have a lot of confidence in where you're sitting. So we're going to close out for the day. As you know, shoot me a text, shoot Justin a text. We both get this text message. Phone number is (602) 704-5574. And until next time, own your wealth, make an impact, and always be a pro.