Why Diversifying Your Portfolio Feels So Awful
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today's episode 401. It's titled, Why Diversifying Your Portfolio Feels So Awful.

Around the year 2000, two of my institutional clients were a university endowment and a private foundation. The head of the investment committee at the university endowment was an incredibly successful stock picker who focused on concentrated positions in mostly growth-oriented tech stocks.

Meanwhile, the private foundation had 60% of their assets with an incredibly successful hedge fund. My job as an investment advisor was to help both of these clients diversify into additional asset categories and investment managers. And it wasn't always easy because on the one side, this hedge fund had done incredibly well and continued to do incredibly well. But what if they didn't?

the client had a significant amount at stake with one manager. The same for the university endowment. If it focused on just investing in a handful of stocks, Warren Buffett at the 1996 shareholder meeting for Berkshire Hathaway said, we think diversification as practice generally makes very little sense for anyone that knows what they're doing. Diversification is a protection against ignorance.

If you want to make sure that nothing bad happens to you relative to the market, you own everything. There's nothing wrong with that. That is a perfectly sound approach for somebody that feels like they don't know how to analyze businesses. If you know how to analyze businesses, it's crazy to own 50 stocks, 40 stocks, or 30 stocks. My role as an institutional advisor was to protect clients from

from our collective ignorance. We didn't spend time analyzing individual businesses. Incidentally, I looked. Berkshire Hathaway currently owns 48 stocks, so more than Buffett's 30 that he thought was crazy to own. But in Buffett's defense, the portfolio is very concentrated. The top 10 holdings make up 85% of Berkshire's stock portfolio. And its single largest holding, Apple, makes up

makes up 38% of its portfolio. What does it mean though to analyze a business as Buffett suggests? It means to determine its value, what it's worth, to go through the financials, to go through the prospects,

This is what investment managers do. They try to determine the value of a company on a per share basis. And then they purchase the stock if they believe a business is worth more on a per share basis than what the consensus values the business at. The consensus being whatever the current stock price is. If the business analysis suggests the stock is worth more than it's trading today, then it should be bought.

When an investor does that, buys a stock that they believe it's mispriced, they're saying the consensus is wrong, even though thousands of other investors, many of which have analyzed the businesses and decided it was worth closer to what they paid for the stock, but that other things will happen to help the stock go higher.

Now, I have no doubt there are incredibly successful stock pickers who have a competitive edge in picking individual stocks. I've met them personally. I've invested with them, as have my former clients. But that skill, the ability to identify missed priced stocks, stocks that are undervalued, it's extremely rare. Why is it that Warren Buffett and Charlie Munger are so renowned?

It's because they have a very rare skill at identifying undervalued businesses. Most of us, including most professional investors, don't have the skill to analyze businesses. Now, we can analyze a business, but to be able to determine ahead of time that it's mispriced, that's way more challenging. And that's why we invest.

invest mostly in index funds and ETFs. And professional investors that are running actively managed mutual funds, if they're not skilled, even though they think they might be, then they will underperform their benchmarks and their peers, as do most active managers, underperform index funds or ETFs of a similar strategy.

Once an investor decides they don't have the skill to pick individual stocks, then they have to decide which index funds or ETFs to own. I suspect if I would ask this investment committee chair or former committee chair at this university client which ETF to buy, he would recommend QQQ, the NASDAQ 100 ETF, because it very much mimics his style of investing. QQQ owns 102 stocks. Even

Even though the ETF has lost 25% year-to-date, it has performed incredibly well over the past decade. 17% annualized return. That's all you would need to own. I suspect your portfolio isn't 100% QQQ. But maybe it's 100% your stock portfolio in the S&P 500 index.

Or the Vanguard Total Stock Market ETF, VTI. So it's all U.S. stocks. That's also done extremely well over the past decade. More diversified, less concentrated than QQQ, but it's returned 13% annualized over the past decade, ending August 31st, 2022. Incredibly good performance.

However, if you diversified outside of the U.S., owned the global stock market, as represented by the MSCI All-Country World Index, it's only returned 8.7% annualized over the past decade, and having that non-U.S. exposure is what dragged down performance. The 10-year return of the MSCI All-Country World Index, XUS, is 5% annualized.

over the past decade. It's returned less than half than investing in U.S. stocks. We had a discussion about this on a Money for the Restless Plus forum, and a member felt bad. He felt like the biggest mistake he had made in investing over the past five years was to invest outside of the U.S., and from a performance standpoint, it didn't help, and it feels bad. Diversification is protection against ignorance. If we don't know what's going to happen, we diversify.

Most people don't know what's going to happen, which means when we diversify, there will always be some asset class, some segment of the market that does better than our portfolio. We will always be missing out on something because we didn't invest in something or we didn't put a big enough weight in something or something that we did invest in hasn't done very well, such as emerging market stocks.

which have returned only 3% annualized over the past decade. Maybe we invested in non-US value stocks, which returned 4% annualized over the past decade. Any diversification that we did outside of QQQ in the past decade cost us performance. That's how diversification works. If we always compare our portfolio against the best performing asset class or segment, it will always lag.

What makes it so difficult this time is how long it's been with the U.S. outperforming non-U.S. stocks. The reality, though, is the U.S. doesn't always outperform non-U.S. I went through a data set from MSCI and looked at the returns going back to 1969 for the MSCI USA index, U.S. stocks, compared with the world average.

XUS index, which is non-US developed markets. So it excludes emerging markets. So these are all developed markets, Europe, Asia, the Americas, similar risk profile. And I went back and calculated 10-year rolling period starting in 1969. So the first 10-year period went from December 1969 to December 1979. Did that monthly. There were 511 rolling

rolling 10-year periods. Non-U.S. stocks outperformed U.S. stocks 51% of the time. So essentially it was split. Some decades, U.S. did better. Some decades, non-U.S. did better.

For the rolling 10-year periods that began in 1969 through the 10-year period that ended in August 1995, non-U.S. stocks outperformed U.S. stocks 94% of the time. In the 70s, in the 80s, into the mid-90s, non-U.S. stocks outperformed U.S. stocks.

U.S. stocks then outperformed non-U.S. for the 10-year periods ending August 1995 to October 2006. That was an 11-year stretch of U.S. outperformance.

Then non-U.S. outperformed U.S. for rolling 10-year periods from November 2006 to February 2014. That's an eight-year period. As recently as 2014, had you owned or over-weighted non-U.S. stocks, that would have done better than investing entirely in the U.S. stock market. But now we've had a period of eight years since March 2014 when U.S. has outperformed non-U.S. And it feels bad. It

if you've had non-U.S. stock exposure. If we look at the entire 52-year period, the U.S. stock market has returned 9.3% annualized compared to 8.4% annualized for the MSCI World Ex-U.S. Index. U.S. has outperformed. But again, we're looking at a period where U.S. has meaningfully outperformed over the past eight years. If we only look at the returns,

through February 2014, a 44-year period, the world ex-U.S. has returned 9.4% versus 9.1% for the U.S. stock market. Over that 44-year period, non-U.S. outperformed. So this can be very end-period sensitive depending on which areas of the market are doing the best.

Now, that's historical data. Stock returns are driven by three elements. The cash flow, as represented by dividends. How that cash flow is growing over time, how the dividends grow. And that is reflected in whether their earnings are growing over time and to what extent are earnings growing. And the third element is what are investors willing to pay for those earnings and dividends.

The change in valuation can impact returns. These are the building blocks of stock returns. It's how we go about coming up with reasonable assumptions for asset class returns on money for the rest of us. Before we decide whether allocating to non-U.S. stocks in the past five years was a mistake, we need to understand what were the return drivers.

So I compared the Vanguard Total International Stock ETF, VXUS. This is the five-year annualized period that ended July 2022. That's when I had the data through. The return was 2.84%. If you look at the dividend yield, it averaged 2.9% over that period. So basically, the entire return was just the dividend. Earnings per share grew at 4.3%.

But then non-U.S. stocks got cheaper. The decline in the P.E. ratio contributed negative 4.1%.

to the return. So if we combine those three elements together, 2.9% contribution from dividend yield, 4.3% contribution from earnings per share growth, and negative 4.1 due to the decline in the PE ratio, combined is about 3.1% annualized return, which is fairly close to the 2.8% return of the ETF. This decomposition of stock returns, they're approximate, so there's always a little bit of an error, but it's pretty close.

Now, if we compare that to the Vanguard Total Stock Market ETF, VTI, this is all U.S. stocks, it's returned 12% annualized over the past five years, 1.7% contribution from dividend yield,

a massive 13.6% contribution from earnings per share growth, and valuations also fell and contributed negative 2.5% to the overall return. If we combine those three, we get a return of 12.8% versus the actual return of 12%.

Stocks for both U.S. and non-U.S. got cheaper over the past five years, but more so for non-U.S., and that dragged down returns. Dividend yields were higher for non-U.S. stocks, and that contributed about 1.2% return more for non-U.S. stocks because the dividend yields were higher by 1.2% for non-U.S. versus U.S.

But by far the biggest component leading to strong outperformance of U.S. stocks versus non-U.S. stocks over the past five years was earnings growth. 13.6% earnings per share growth for U.S., only 4.3% for non-U.S. A 13.6% annualized earnings per share growth was more than double the 6% average earnings per share growth for U.S.,

U.S. stocks going back to 1950, according to data by Crestmont Research. What happened? In the U.S., companies bought back a significant amount of their shares. By buying back shares, it reduces the number of stock shares outstanding. And even if earnings stays the same, that can boost the earnings per share. And a big contributor to those buybacks was H&M.

A giant windfall the U.S. companies got back in 2018 into 2019 when corporate tax rates were cut. The tax rate was cut, the earnings overall went up, the companies had more cash, and they used it to buy back stocks. Now, it isn't just buybacks, but it's a big contribution to why earnings per share growth grew at more than twice the long-term average.

Before we continue, let me pause and share some words from this week's sponsors. If, as investors, we diversified outside of the U.S. and didn't anticipate U.S. earnings would come in at twice, more than twice the long-term average, three times greater than the non-U.S., I guess we could say that was a mistake, but we didn't know. That's why we diversify, out of ignorance. We don't know.

Incidentally, the dollar strengthened over the past five years, and that had about a 2% per year impact on U.S. versus non-U.S. So if we had hedged our exposure to VXUS, the Vanguard International Stock ETF, that return would have been 4.8% annualized over the past five years rather than 2.8%.

The bottom line is an allocation to non-U.S. stocks underperformed U.S. stocks because P-E ratios got more cheap. Valuations got even more cheap for non-U.S. stocks compared to U.S. Dividend yields were much higher non-U.S., but it was the earnings growth that contributed.

We use those same three elements in estimating returns for different asset classes, different regions of the stock market. Over the next two decades, we expect global stocks to return 6.9% annualized with a range of 3.3% to 8.5%. And what the returns end up being will depend on the dividend yield, the earnings growth, and the change in valuations.

We're assuming that the U.S. stock market, the earnings growth will grow faster than the rest of the world because it isn't just buybacks. That certainly contributes, but we have productivity increases. There are more technology companies in the U.S., so their earnings growth tends to be faster. We're assuming 5.5% nominal earnings growth, about 2%.

two percentage points more than the 3.6% earnings growth for non-U.S. But the dividend yield is much less for U.S. stocks, about 1.5% versus 3.1% for non-U.S. stocks. So double the dividend yield for non-U.S. stocks.

Slower earnings growth and the valuation adjustments are, we have non-U.S. price-to-earnings ratios are currently at 15.1, expected to go up to 16, whereas U.S. is at 20.7, expected to fall to 20. We're not assuming a major decline in U.S. P.E.s.

Now, if you did and research affiliates, for example, does similar type analysis, they're assuming U.S. stocks are going to get much cheaper and that will bring down the overall returns. You also expect U.S. earnings growth to be less than what we're assuming. But we also do ranges of return. But again, this is a bottom up approach using these assumptions.

It's not enough just to feel bad about making an allocation change. We have to understand what drives the returns, what drove the returns, and what are reasonable expectations going forward. I think the U.S. could very much outperform the rest of the world over the next decade. But I'm not entirely positive. And when I look at some of the valuations...

of some of my holdings and some of the holdings in the model portfolio examples on Money for the Restless Plus, they can be compelling. Take the Wisdom Tree Emerging Markets High Dividend ETF, DEM. It's only returned 0.9% over the past decade. It's been a long 10 years. Now, I've only owned it and we've only had it in our models since, I think we added it three years ago in 2020. But you look at the price to earnings ratio of that ETF, it's at 6%.

Its dividend yield is 11.6. Its long-term earnings growth expectation is 6%. Just based on keeping the valuation at 6, we just look at dividend yields and earnings growth. That's a potential return of 17% annualized. And if the P.E. got higher, then the return would be even higher. No, I don't know if that'll...

happen, maybe earnings growth will come in less than that. Maybe the PE for this ETF will get even less expensive. But I'm willing to have an allocation to diversify just in case. And it's not a big allocation. I think in our models, it's 5% of the equity exposure. But doing so reduces the allocation to U.S. stocks. The wisdom tree, Japan, is

Small cap dividend ETF, DFJ, is another ETF in our models and it's in my portfolio. It's returned 5.9% annualized over the past decade.

half the U.S. stock returns. Yet its P.E. is 9.4 versus 20 for the U.S. stock market, and its dividend yield is 3.9% versus 1.5% for the U.S. stock market, and its historical earnings growth has been 12% per year. So based on 12% earnings, 4% dividend yield, that's a 16% return. It

expected without any adjustments in valuation. Now, this ETF and any exposure to Japan on an unhedged basis, which means the ETF was hurt by the weakening Japanese yen, which has plummeted over the past year or so, that's dragged down returns. So if we get a strengthening in the yen, even back to its long-term average, that would also boost returns.

Those are two examples of diversifying that in the short term have caused pain, made us feel bad, regret. But if we look at the drivers, the current dividend yield, earnings growth, potential change in valuation, we continue to own them. At least I do. But it's hard when we think about what could go wrong.

There will likely be a recession in Europe due to the energy price shock. Natural gas prices in Europe a year ago were 50 euro per megawatt hour. Today, they're 237 euro per megawatt hour. Last week,

They reached €339 per megawatt hour after Gazprom shut down the Nord Stream pipeline from Russia to Germany. Russia's gas exports to Europe have fallen 40% from January to July, but 70% in June to July and now essentially will be zero. That is an incredible hit.

That, in some ways, hasn't hurt Russia at all. Even delivering at 20% capacity for that pipeline, Russia was able to export $50 billion in natural gas. Two to three times its normal amount. Not the amount of gas, but the total value because the price shot up. Even though they were exporting less, they made more money. Two to three times more money than average.

been a very effective way for Russia to retaliate against sanctions. Cut exports, but make a lot of money because prices have jumped. Now, Europe will adapt and is adapting. They're close to reaching their target of 80% capacity of storage. There are three new floating storage regasification units that will arrive in Germany this winter to allow them to import more liquefied natural gas.

There potentially will be rationing, but even despite that, households and businesses in Europe are conserving more. Capital Economics estimates that energy demand has fallen 12% year over year in the first half of 2020.

of 2022. There are severe problems in Europe, but in our ignorance, we don't know exactly how they're going to work out, and we don't know how much is already reflected in stock prices, which are significantly less expensive in Europe than they are in the U.S., with PEs closer to 15 in Europe versus over 20 for the U.S. stock market. But the U.S. is not without its problems. High inflation, housing shortage, poverty,

Political instability, crime, falling education scores. There's talk of potential civil war. Now, I don't think so. I certainly pray that that's not the case. But some of the underlying political trends and rhetoric...

anger, falsehoods, the U.S. has significant risk, which is why I don't put 100% of my stock exposure in the U.S., nor do I think you should either. Now, I think you should be diversified into many different asset classes, many of which we've shared on the podcast and continue to provide education, both free and paid, on

on money for the rest of the plus. So you can learn different asset classes, understand the drivers of the returns of those asset classes, come educated on them, and so then you can diversify and not be entirely dependent on the return of a handful of stocks in the technology space, just in case, diversifying out of our ignorance. Now, if you can analyze businesses, identify mispriced stocks where the consensus is

of investors, many incredibly smart investors are wrong, then go for it. I just wouldn't put all your portfolio in that just in case. And don't diversify blindly. Understand what has to happen for a reasonable return to come about. We can know the return drivers and we'll be able to look to see if those drivers evolved as was expected.

That's how we invest. We diversify and we hope for the best. And if you're retired, we diversify even more by not depending entirely on our investment portfolio. Get some guaranteed income sources. If you don't have a pension, consider an immediate annuity or some other type of government-sponsored retirement plan so that all of your retirement isn't dependent on how you invest. That's incredibly stressful.

and can become even more stressful as you age. Diversifying feels awful because something always does better. That's the nature of diversification. You have many asset classes. Some will do better. Some will do worse. And ultimately, the returns will offset and hopefully meet our long-term return objective. That's episode 401. Thanks for listening.

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