How Much Global Diversification Do You Really Need?


Last week, I wrote a post about skipping the investing buffet.  In that post, I argued that investors are better served by avoiding most of the “buffet” that is the investing world.

Unfortunately, many readers seemed to think I was advocating for the buying of individual stocks (I wasn’t!).

I firmly believe the vast array of investing products available do absolutely nothing for small investors… except lower your potential for good long-term returns, and raise your expenses.

Yes, there’s a lot of neat products out there — International funds, emerging market funds, China funds, energy funds, bond funds, precious metal funds, and so forth.

But most investors don’t need any of that.  It’s just noise.  Noise that’s distracting you from what you really need — Your fair share of the global market economy… held for as long as possible, with as few fees as possible.

But how do we get proper global diversification without getting into the “noise”?

 

Just One Fund?

Let’s take the punch card concept one step further — What if I said, “An investor only needs one global investment for his or her entire lifetime”.

Not one domestic investment and one international investment — just one investment, period!  In doing so, our hypothetical investor could average very nice returns over an entire lifetime.

What would this hypothetical fund look like?  To begin, the fees that fund charged would need to be tiny — 0.1% for example.

The fund would also need to be largely in stocks to realize good long term returns.

Now, what about diversification?  This investment would need to have a certain amount of global diversification, and this is where most investors get tripped up.

Obviously the world is a very dynamic place; the global mix of business is changing constantly.

How diversified does an investor really need to be?  Should we seek out alternative investments in far flung countries to reach some mythical level of diversification?

To answer this question, let’s look at where the money is:

nominal
A mere 7 countries make up 75% of nominal global GDP.  (courtesy of wikipedia)

The three largest contributors to global GDP are the US, the EU, and China.  What’s even more interesting, 7 countries make up 75% of global GDP.

A simple way to invest in these 7 regions, are big global companies that reach customers around the world.  Afterall, it’s not where a stock is traded that matters, it’s where the sales are located.

This narrows down our search considerably.  Life just got simpler!  Yay!

Instead of worrying about investing in places like Turkmenistan, we only need to invest in the biggest companies of very developed countries.

While developing countries might see large-ish GDP growth, the companies listed on developing stock exchanges rarely have a global reach into those top 7 economies.  Therefore, developing markets are probably not a good fit for our hypothetical global investment.

 

What Index Fits the Bill?

Given this criteria, I wondered if any index fit this description for our hypothetical “One Investment To Rule Them All“.

A few of the big global indexes kept popping up in my search:

There are literally dozens of other global indexes that could fit the bill, but for the sake of this post I’m limiting it to just these 3 indexes.

In analyzing the 3, I noticed something very interesting — despite my attempt at taking a global approach, all of these indexes are heavily weighted (>50%) toward the United States.

Take a look:

global funds

If you look at the top holdings of the indexes, it reads like a listing of big US companies — Apple, Microsoft, Google, Facebook, Johnson & Johnson, and so forth.

Why?  These “global indexes” are heavily weighted towards U.S. companies because (1) these are market cap weighted indexes, and (2) the world’s largest global companies are simply listed in the U.S.

Not only that, but the funds that track these global indexes charge significantly higher fees.  Yikes!

Are these “global indexes” really worth investing in if they hold 59% of the same companies as the S&P 500 index?  Maybe not!



Stock Exchange Location Vs. Sales Location

A major assumption most investors make about “global investments” is that a company’s sales are primarily located in the same country as their stock listing.

Which isn’t true — these big global firms sell products to customers around the globe.  The stock listing location has very little bearing on where product sales actually happen.

A company like Nestle (for example) may be listed in Switzerland, but they sure as hell don’t just sell chocolate bars in Switzerland.  Which means, the country weightings you find associated with international funds are basically useless, unless you happen to know the global breakdown of sales for every company in a given index.

Which I don’t, and couldn’t find published anywhere!

However, the good ole S&P 500 does have certain data like this available: here

We can clearly see that international product sales make-up about 45% of sales for companies in the S&P 500!  This must also mean that 55% of all S&P 500 sales are domestic sales.

Those weightings really aren’t that different from the international index fund weightings we looked at earlier!  So what’s the point of investing in those “global funds” with double the fees?

Think about it!   We get all that same global diversification by investing in a simple and cheap S&P 500 index fund!

 

The Verdict

I can’t stress my earlier point enough — Stock listing location is not the same as product sales location.

An investor can attempt to chase international diversification based upon a stock’s listing location, but it’s basically a useless exercise, which I’ve attempted to illustrate here.

You don’t know where the sales are happening, only where the company’s stock is traded!

Large global firms will sell products around the globe wherever those products turn a profit.  Investors shouldn’t be attempting to follow dollars around the world by finding some perfect global GDP distribution.  It’s an exercise in failure and “not having enough data”.

My solution is — don’t try.  Instead, focus your efforts on investing as efficiently as possible.  Let the global companies of the world chase that money around the globe for you.  They’ll do it in the most efficient and profitable way possible.

Certain segments of global GDP are always going to be difficult to capture — We simply don’t have good enough access to certain markets like China or India.   Don’t worry about it!

It’s almost inevitable that we’ll see companies like Alibaba (a Chinese company is listed on the NYSE) added to the S&P 500 as they begin to take up a larger share of global GDP.

Already a handful of the companies headquartered outside the United States are listed in the index.

So stop chasing those “global” investments already!

In the case of the S&P 500, we can capture a 55% domestic / 45% international sales distribution with an expense ratio of 0.1%.  For most investors this is plenty of global diversification.  It’s also an extremely efficient investment, with very low fees.

I see no reason why that would change anytime soon — it’s a great choice for your global investing dollars.

 

[Image Credit: Flickr, Wikipedia]

20 thoughts on “How Much Global Diversification Do You Really Need?

  • June 17, 2017 at 3:55 AM
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    I really like this! It’s even more succinct than how Jim Collin puts it in his book “The Simple Path to Wealth”.

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    • June 18, 2017 at 9:42 AM
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      I haven’t read his book yet, but that sounds like a compliment! I’ll take it!

      Reply
  • June 17, 2017 at 4:20 AM
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    From an ROI perspective your right. The s and p 500 is as diverse as most foreign large cap stocks. The issue is the market is not always rational. So sometimes similar stocks are priced lower based on listing location. I’d argue we have that now. So investing in international sectors is a good deal imho. Pe for msce for example is currently three to four less then S&P.

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    • June 17, 2017 at 9:13 AM
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      There’s also good arguments for this under pricing. U.S. markets are better regulated and thus better protected from fraud (supposedly). Thus less risky.

      One could argue that markets are actually being quite rational in this regard.

      Reply
  • June 17, 2017 at 5:08 AM
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    The only reason why I don’t invest in global or international funds is because I know nothing about these economies. For me personally, the US economy is more stable and predictable because of the market and its cycles. But in Communists regimes everything can be turned down in a minute (ask he how do I know that)

    But it’s for me personally. Anyway, it’s all about risk tolerance
    Friendly Russian recently posted…Living The American Dream – Millionaire Before 50

    Reply
    • June 18, 2017 at 9:49 AM
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      I guess China is technically communist, but they certainly do a good job acting like capitalists these days.

      As you probably noticed, no other communist regime is even in the top 10 of world GDP. https://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)

      Like I said in the post, trying to invest in countries outside the top 7 is probably not worth most investor’s time. Let global corporations chase those dollars!

      Reply
  • June 17, 2017 at 10:53 AM
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    Thank you for sharing. I like Vanguard’s total world index fund Mr. Tako. But the fees are higher than their others. People can replicate it by just doing vanguard’s total stock market index fund and total international index fund. These two are where the bulk of our tax-advantaged money’s in.

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  • June 17, 2017 at 2:06 PM
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    Excellent article. People assume that the S&P 500 is only domestic investment. Great illustration on explaining that the Fortune 500 companies have significant international sales. Don’t people all over the world use iPhones or use Microsoft Office? Of course they do… Thanks again!

    Reply
    • June 18, 2017 at 9:40 AM
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      Actually, if you check out the link in my post, you’ll see the international revenues range varies from 43% – 46% on any given year.

      I haven’t looked very deeply into the reasons why the variation, but it doesn’t seem to be growing. It’s probably inversely correlated with USD currency rates, but I haven’t done the research on that yet.

      Reply
  • June 18, 2017 at 8:19 AM
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    Great minds think alike! You are making the same point that JLCollins did in The Simple Path to Wealth. Have you read his book?

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    • June 18, 2017 at 9:37 AM
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      I’ve heard of his book, but haven’t read it yet. We probably reached similar conclusions from the same data points.

      Reply
  • June 18, 2017 at 7:05 PM
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    Great minds think alike. Best to keeps things easy & simple so you can enjoy life. 🙂

    Reply
  • June 19, 2017 at 1:37 PM
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    Hmm, great point, I didn’t really think about that when I started investing so I do have a significant share in “emerging markets” and “international markets” stocks… which, as you mention, might not make so much sense now that I think about it.

    Reply
  • June 20, 2017 at 9:16 AM
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    I will be the dissenting voice here. I agree that the S&P 500 has enough internal market exposure. That’s the same point Benjamin Graham made in his book. However, the valuation is very high historically. If we add more money at this point, we’d probably get low single digit ROI according to Mr. Graham and other experts.
    International equities are priced better at this time. Why not shift some money to international stock indexes to take advantage of this? Valuation matters too, not just market exposure.

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    • June 21, 2017 at 12:26 AM
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      I don’t disagree Joe. No investing decision should be made absent of valuation. For the purposes of this post however, I didn’t get into risk-reward valuation adjustments.

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  • June 22, 2017 at 11:38 AM
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    Speaking of Buffett, I am fairly certain that his portfolio is 100% US companies. Granted he is an exception but the point still gets across. Diversification among sectors is smart. But globally is not really needed. One can simply buy a low expense S&P500 fund and call it a day if they really want to. It will probably perform just as well, if not better.

    Reply

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