Episode 40 – Diversify Broadly, Both Across and Within Global Asset Classes

Welcome to Market Perspectives, a Mercer Advisors podcast. Today’s episode is titled Diversify Broadly, both across and within global asset classes. And it’s the second one of our foundational investing principles here at Mercer Advisors. I’m Josh Zumbrun, I’m the director of external communications at Mercer Advisors and I’m joined today by Don Calcagni, our chief investment officer. Don, thanks so much for being with us today.

Josh, it’s fun to be here. It is a fairly crisp early fall day here. We’re recording I know on August twenty fifth.

But in my hometown, Penn State University’s main campus, school is back in session. And I think think today’s episode is is gonna feel like for many of us that we’ve gone back to school. Maybe a little bit of math. So a little bit of a trigger warning perhaps for our audience today that Josh today we are gonna discuss a little bit of math.

Good stuff and this is really an important one, right? So, we’re going through and we’re kind of looking at the Mercer advisors evidence based investment philosophy and the five principles that really guide the way we at Mercer advisors approach investing and this is our second episode on this topic. First episode looked at the principle that financial planning is a prerequisite to successful investing and today, we’re looking at the second pillar which is about diversifying broadly. And so, Don, set this up for us. Mean, kind of explain how you think about what, you know, the problem that investors are trying to solve and what this principle why this principle applies.

Well, mean, first and foremost, Josh, it’s important to remember that when we invest and I don’t care if you are a multi billion dollar family or someone who has just graduated college and is beginning to fund a Roth IRA, we are all investing for a specific purpose to achieve an objective. The alternative is we could just consume our wealth. Right? We go out and buy all the things that we want or we could go do all of the things that we want to do.

But investing is the opposite. Investing is an exercise where we purposefully say, you know what, I’m not going to consume these dollars. I’m not going to spend them. I’m going to invest them for the future.

And so when we invest, it’s important to remember that investing is not an innate human activity. It’s not instinctual. Like we didn’t evolve on the plains of Africa thinking, gee, someday we want to be able to trade foreign currency derivatives at four am, right? We’re investing because we want to achieve more security, more comfort, more enjoyment at some point in the future.

And so the question is, what is the most reliable, effective way to do that in a way to where we really minimize the probability of being disappointed and not being able to achieve those future objectives. And that really gets back to that first principle, having a financial plan. Financial plan is about identifying what success looks like in the future. It identifies what we’re investing for, and we’re mapping out a strategy for how best to get there.

And diversification with respect to investing and putting those dollars at risk.

Diversification is the best approach to minimizing risk, increasing our returns, but also improving the probability, increasing the odds, maximizing the odds that we’re going to achieve our long term objective. Diversification does all three of those things.

Now, I guess to kind of set it up, there’s there’s maybe an opposite view. Right? On the one hand, we believe you should diversify broadly but there is a view out there, sometimes it’s explicitly stated and sometimes it’s implicit that you can over diversify and that maybe you can you can own too many things and actually you should just pick a smaller handful of winners is kind of the idea that some people have and they express that different ways. They say, oh, I should have an active stock picker picking the best stocks for me or maybe they say, oh, well, you know, there’s the big winners in today’s market are gonna be winners forever and I should own more of those stocks. And so Don, kind of walk through diversification especially kind of against that alternate view that’s actually quite common that maybe I shouldn’t be super diversified.

It is a very common view, Josh. You know, we were talking before the show and I shared with you that this is probably the most popular objection to our investment philosophy. I often hear professionals. I hear advisers. And I certainly hear many investors make the claim that it is possible to be over diversified. Well, me I’m not going to mince words here. Let me be absolutely clear.

Over diversification is mathematically impossible. It is impossible. Over diversification is what I call financial pornography. It’s just wrong.

It’s just, it doesn’t make any sense. Right? And so these are common urban myths, urban legends that have found their way into the investment profession. And this is why we’re going back to school today, Josh.

Right? We’re going to revisit some of the basic arithmetic behind diversification. But before we get into the math, Josh, I actually wanted to back up for a moment. This this argument that one can be over diversified, that we can perhaps just hire some rock star manager guru to beat the market for us.

There’s also real world evidence, mountains of real world evidence that this is just wrong. It’s virtually impossible. That’s not to say that there aren’t some people who just get lucky. Right think of a Powerball ticket.

Right there’s a reason why we use Powerballs and lotteries to fund nursing homes in Pennsylvania. Right because it’s a great it’s a great way to raise a lot of money. But sure somebody, there’s gonna be one winner out there. And of course we all look at that one winner, the person that won this gigantic prize and think, see, it can happen.

But if we look at the financial markets and we actually look at the real world evidence, it is stark. It is unequivocally clear that being under diversified is a train wreck and it does not make any sense with respect to our financial planning. So for those listeners that can see our screen, what sharing with you is the probability, the odds that a mutual fund manager and what we call a traditional active mutual fund manager, the odds that they can beat their own benchmark, a very simple, highly diversified asset class based benchmark. And the odds are abysmal.

Absolutely abysmal. If we just look at U. S. Large cap mutual fund managers, one of the things we observe is that these managers, about ninety percent of them are concentrated.

They’re not trying to diversify broadly. They own a relative handful of stocks. What we see is that over any one year period, their odds of outperforming a very simple highly diversified benchmark is only twenty one percent. Me say that a little differently Josh.

Have about a seventy nine percent odds of losing that bet.

Those are horrible odds. You have better odds in Las Vegas.

So rather than try to hire some active manager, you’re better off just going to Vegas and playing blackjack, have some fun, have a few drinks.

And you likely paid a higher management fee for the privilege as well.

No doubt, right? No doubt, right?

So and this odds of underperformance actually gets worse with time over a fifteen year period Josh.

Their odds of beating a highly diversified benchmark it falls from twenty one percent to ten percent. And I know we still have naysayers out there Josh that are saying so Don what you’re saying is there’s still a chance.

There’s a chance.

There’s a chance that I could beat the market. And I would say sure. Yeah, there is. It’s about ten percent.

But there’s about a ninety percent chance then what that means is you’re not going to achieve your goals whether that be retirement, whether it be whether it be college education for your child, right? And those are very serious downside risks, we would argue, that just doesn’t make any sense. Why would you why would you jeopardize your financial objectives by investing in power ball tickets? So our view is that doesn’t make a lot of sense.

And what you see too in this chart is it’s not just a large cap phenomenon. It’s small cap, it’s mid cap, it’s international, it’s emerging markets. It’s there’s there’s a bigger version of this table that actually shows that kind of across thirty different things you might consider investing in this principle applies.

Absolutely. We are by no means cherry picking the data, right? Whether we’re talking stocks, bonds, U. S.

Stocks, non U. S. Stocks, emerging markets, big companies, small companies, sectors, doesn’t matter. These managers are abysmally underperforming a highly diversified benchmark.

And so this is just the real world data, Josh. We’re not even getting into the arithmetic yet. We’re just looking at real world data and there’s a lot of reasons why we see this underperformance. Another chart that we have here for our listeners who can see our screen is we can we’re showing that over time the top winners, the biggest stocks in the market, they change.

Companies come and companies go, right? The big winners that we have in twenty twenty five, they didn’t even exist ten, fifteen years ago. Right? Think of Sears, right?

Many of our listeners I hope can still remember, what who Sears used to be. Sears was the Amazon dot com of the twentieth century. Sears does not exist anymore. It’s bankrupt, right?

So companies come and go. The big winners in the market come and go. And a little known fact Josh that our listeners may not be aware of is that if you look at all of the stocks that have ever been publicly traded throughout U. S.

Stock market history, all of them, thousands and thousands and thousands of companies, all of the gains that all of the wealth that has been created by the U. S. Stock market since nineteen twenty six comes from four percent of all of the stocks that were ever publicly traded. That includes those that still exist today.

That includes those that have been delisted. That includes those that have gone bankrupt. Sears, Enron, WorldCom, all of these companies that have been around for many, many years that no longer exist. This includes all of the stocks.

Four percent, nearly sixty percent, sixty percent of all stocks that have ever been publicly traded actually destroyed value, meaning the investor lost money. So if you think about it Josh, you got to ask yourself what are the odds? What are the odds that one of these great managers, these rockstar gurus that you know pay lots of money to be on television, What are the odds that they’re going to capture those four percent of big winners that drive market returns? And the odds are very low and we see that when we look at the real world outperformance.

Really I should say the real world underperformance of these managers. And so how do we ensure that we get those four percent of big winners that are gonna create lots of stock market wealth? We diversify. We diversify broadly.

We own hundreds and hundreds if not thousands and thousands of stocks, not just in the U. S. But broadly. So Josh, that’s the real world evidence.

So that’s not us just even getting into any math.

That’s just the data. That’s what we see every day in the stock market.

It’s such a striking point that the kind of what diversification does for you is it means that you automatically are buying those stocks before they become the big winners. It’s not like you no one has a track record of identifying what those four percent of companies are gonna be, but with diversification, you’re kind of buying them anyway. And Don, you’ve talked about I love this. You talk about the person who who went into a coma, who went into a rip, free and winkle nap and woke up but had a diversified portfolio.

Tell this to tell this to our listeners because this is so relevant for thinking about Yeah, I often joke Josh that look if in nineteen ninety, right, I was in high school.

In nineteen ninety if all you owned was an S and P five hundred index fund. Let’s just assume that’s all you own, right? And you fell asleep.

And you woke up this morning. And you did nothing over the past forty years or thirty six years. You’ve done nothing over that horizon. You just woke up. Guess what?

You already own a whole bunch of AI stocks. You own Apple. You own Amazon. You own Meta.

You own Nvidia. You own all of these big companies that didn’t even exist in nineteen ninety when you fell asleep. And it’s because of the construction of a highly diversified index based strategy, right? Just through the natural reconstitution of a highly diversified portfolio, you’re going to get exposure to the big names.

And interestingly, Josh, if you look over that thirty six year horizon, you can probably count on two hands how many mutual fund managers actually outperformed the S and P five hundred index. They are exceptionally, an exceptional few managers who’ve actually been able to do that. And I know we have naysayers that say, but Don you’re saying there’s still a chance. I’m gonna swing.

I want that power ball ticket. And what we’re saying is you don’t need to do that. In fact it’s better that you don’t.

Now, Don, let’s get into some of the math here. One of the claims that you that we’re pushing back on is this idea that you can over diversify. And when we talk about over diversification, we’re not just talking about, owning kind of a lot of stocks. We’re talking about across asset classes as well. Right? And so walk us through some of this math of of why it really is a misconception to think that you can over diversify.

So the reason why diversification is impossible is because companies and or asset classes, right? So think U. S. Large companies as a group, U.

S. Small companies as a group, non U. S. Companies, they are not perfectly correlated. So what does that mean in English?

What it means is they don’t move in the same direction with the same amount of force. Right?

So why not? Well, companies are engaged in different businesses, different industries. They have different, what we call, capital structures in terms of how they’ve chosen to finance their business. They have different management teams.

They have different strategies. They have different geographic footprints. Some companies operate in different geographic markets, different countries, continents, things like that. Some companies have greater exposure to adverse weather events, for example, than other types of companies.

All of this is to say is that Josh, companies and different asset classes have different exposure, different sensitivities to what’s happening in the broader economy. Some companies are more interest rate sensitive than others. And so what that means is their stock prices, meaning the returns that we earn as investors, are all moving in somewhat different directions. They may be moving in the same direction.

So for example, maybe Coke and Pepsi rise in value on any given day, but maybe one of those rises more than the other. That means that they are not perfectly correlated. So anytime you have companies or just assets or asset classes that are not perfectly correlated, that adds diversification power to your portfolio. And this concept of correlation is a critical variable in the formula that we use to calculate portfolio risk.

Right? I’m gonna spare our listeners and I’m not gonna share the actual formula, but you can look it up online. Just look up the formula for portfolio variance and you’re gonna see a little Greek term in there. It looks like the letter P.

It’s the Greek term Rho, which stands for correlation. Now why is it such a big deal? Show me a picture. Well, you can see our screen here for a moment, I just want to draw your attention to the top line where we’re beginning with one asset class, just one, that has a risk level.

That’s what we call standard deviation, but we’re just going to call it risk.

And if all you owned was just that one asset class in your portfolio, because maybe you don’t want to be quote over diversified, your portfolio has a risk level of twenty percent. If that’s all you own and if that is the risk level of that asset class, your portfolio has a risk level of twenty percent. We’re also going to assume that that portfolio has a return, an expected return of eight percent. So eight percent return, twenty percent risk.

Now something very magical happens when we add the second asset or asset class to the portfolio. Let’s assume that this second addition to the portfolio, Josh, has the same exact risk, twenty percent, and the same exact return, eight percent. But they’re not perfectly correlated. Like I said, Coke structures, different management teams, different products.

I prefer Pepsi. Other people prefer Coke. And so they’re not perfectly correlated. And so these two asset classes, because they’re not perfectly correlated, something very magical happens.

You’ll see that at the portfolio level that the risk actually falls from twenty percent to eighteen point four four. And that’s because they’re not perfectly correlated. They’re not moving in the same direction at the same time with the same amount of force.

And then additionally, what we see is the compound return, the geometric return increases.

So like I said, when we started our conversation, three very magical things happen by way of diversification. Number one, we reduce risk. We see that at work here. Number two, we increase returns. And number three, we increase the odds of the probability, the reliability of achieving our goals, our financial planning goals, whether that be college, retirement, or whatever the case might be. As we continue to add more and more asset classes to the portfolio, the risk level continues to decline.

So much so that by the time we added ten asset classes to this particular hypothetical portfolio here on our screen, we took the risk level Josh from twenty percent down to seventeen point zero nine percent and importantly, the geometric return increased from eight percent to eight point five four percent. That’s an additional fifty four basis points annually in return that the portfolio captures. Now you may be thinking, well, that doesn’t sound like a lot. Over thirty years for a one million dollars portfolio, Josh, that works out to one point six million dollars in extra wealth.

I’ve never met a human being that says I don’t need an extra one point six million dollars in extra wealth. This is free money. We often say that diversification is the only free lunch and indeed it is. And you see it at work right here.

And you don’t need a PhD in arithmetic to get this. Right?

Smaller companies are going to have different exposures to what’s happening in the economy than bigger companies. Right? If you’re a Wall Street investment bank, you are gonna be more sensitive to changes in interest rates than perhaps a small feed mill in Northern Pennsylvania that has no debt just sells locally, right? So these things make intuitive sense that these companies are gonna behave very differently depending on what’s happening in the economy. So not just empirically, Josh, like if we look at the real world evidence, we see that broad, broad diversification, the broadest possible wins most of the time. But also it’s backed up by theory and economic intuition and probability theory makes a lot of sense. It’s the best approach to building and managing portfolios, bar none.

It’s really it’s really quite a powerful table when you spend some time and and figure out what it what it what it means. It’s really remarkable. And it’s just kind of the mathematics of it. It’s not relying on a lot of theoretical assumptions. This is really just what the math leads you to conclude.

Correct, correct. Now it’s definitely the best approach to building a diversified portfolio.

And for those who don’t wanna look at a bunch of numbers, maybe they just wanna see a visualization. Just imagine two bell curves.

One bell curve is a less diversified portfolio. Let’s call it a portfolio of just one stock.

And then think of a highly diversified portfolio. And let’s overlap those for a moment. What you’re gonna see is all of this downside risk that comes with owning an undiversified portfolio.

This extra upside potential that we see here on the screen, that’s your lottery ticket. That’s your power ball payoff that I know a lot of folks are trying to achieve, right?

If I could have just picked that one company ten years ago before everyone already knew about it.

If I could have bought Apple before it went public, right? Like how great would that have been, right? But what we see is this undiversified single stock portfolio, it’s shifted to the left on our screen. That’s bad.

That means that the odds, the likelihood of you achieving your long term goals is now materially less than just owning a highly diversified portfolio. So the takeaway Josh here is no matter how we do the math, no matter how we visualize it, and even if you don’t want to do math, right, even if you just want to look at real world returns data, the truth remains that diversification is by far the best approach to achieving our long term goals. Diversification, and I just want to drive these three points home to our listeners. Diversification reduces risk. Number one, I think that’s pretty intuitive. I think a lot of folks understand that.

Number two, it increases returns. And I think that’s less widely understood is that second point that it increases returns. And then finally, it increases the probability, the reliability of our portfolio when it comes to achieving our financial planning objectives, right? And all of us remember back to our opening conversation, we’re investing for a reason, Right?

We’re investing our capital because we want to achieve certain objectives. Those objectives, like I said, could be retirement, be college, could be whatever. But let’s not forget that we invest for a purpose. There’s a reason, there’s a goal.

If you’re saving for retirement, don’t necessarily have ten chances to get it right. You kind of want to go with the strategy that has the highest probability of getting you there.

You would think, right? That’s the goal, right? Is Is to achieve our long term goals. I tell folks, look, investing is, like I said earlier, it’s about putting capital at risk.

It’s diversifying it to achieve a long term goal. If what you’re really looking for is entertainment, there’s lots of other ways that we as humans can spend our capital to be entertained. We could go to Vegas, we can go to Atlantic City, right? There’s all these online betting forums that we have nowadays that are suddenly very popular.

But I would not do it with your life savings. I would not do it with your with your kids college education fund by any stretch.

And so Don, sum this up for our listeners. There’s kind of, you mentioned it before, but there’s really three big takeaways that you want people to have about diversification. So let’s just hit that once again.

Yeah. Josh, diversification is so critical. And it’s critical to financial success because it does three things.

First, broad diversification, both within and across major asset classes that reduces portfolio risk.

Owning hundreds of U. S. Stocks is better than owning twenty, thirty, forty, or fifty.

Owning more than U. S. Stocks, for example, owning hundreds and hundreds of U. S. Stocks, but also thousands of global stocks, that reduces risk.

Number two, it increases your compounding, your compound returns.

It increases your geometric returns. These are the returns that matter.

All right. So that’s number two. It increases returns. Finally, is because of that increased return and reduced risk, it increases the odds of achieving our goals.

It increases the probability of success for our financial plan. And Josh, finance, this is the only free lunch. Diversification is the only free lunch that exists in finance. Like I said, lower risk, higher returns, better outcomes.

Where do I sign? That makes all the sense in the world from an investment management perspective. So if anyone is telling our listeners that they are over diversified, that over diversification is possible, I would I would hold on to your wallet, turn around and run and feel free to come back and re listen again to this podcast.

That’s right. It’s a little bit it’s a little bit like the odyssey, right? You’re on the boat and you hear this siren song on TV constantly of pick the hot stock and and you know, don’t don’t own these assets, own these assets. These are gonna be the winners There’s like this constant temptation out there that, Oh, maybe I’m too diversified and I just need to pick the winners just to go heavier on the winners. Don, I think this is a really great helpful reminder to tie yourself to that ship and not give into this temptation because the math shows it doesn’t work out for people.

I would add one more anecdote to that. You know, since this is a new school year has begun, I would remind our listeners that television, the media, the internet, none of it sells education. If you want real world education, enroll in an educational institution, right? Take some classes in investing or probability theory.

Remember the media sells advertising and you are the product, right? They do not sell education. So be very careful. I agree with you. Resist that siren song. It is not the education that it portends to be.

Don, thank you so much for being here today to talk about this.

Thank you, Josh.

If you’re already a Mercer Advisors client, don’t hesitate to reach out to your advisor to talk about any of this. And, if you’re not a Mercer advisors client but you’re interested in more information, head to our website merceradvisors dot com, set up a phone call. Thank you so much for being with us today on market perspectives.

This presentation by Mercer Global Advisors Incorporated also known as Mercer advisors was intended for general information purposes only. No portion of the presentation serves as the receipt of or as a substitute for personalized investment advice from Mercer advisors. All expressions of opinion reflect the judgment of the speaker as of the date of recording and are subject to change.