Is Diversification Still a “Free Lunch”?

Harry Markowitz, Nobel Prize winning economist and founder of Modern Portfolio Theory, once claimed diversification is the only free lunch in finance.  He theorized that a diversified portfolio could greatly reduce market risk without sacrificing returns.  This idea applies to different asset classes (stocks, bonds, commodities, etc.) as well as within asset classes (purchasing many different stocks instead of just a handful).  Modern Portfolio Theory has been the foundation for most professional investment managers for decades. However, some investors question its usefulness when certain stocks, sectors, or even country markets experience outsized gains. We will address the efficacy of diversification both within U.S. markets and on a global scale.

Domestic Equity Markets

The S&P 500 index[1] has annualized nearly 14% since 2010. Technology stocks are outperforming with the NASDAQ composite (a tech-heavy U.S. index) annualizing over 17% since 2010. That dispersion is more pronounced this year, with the S&P up around 10.5% while the NASDAQ is up 17.5% (through September).

This may not come as a surprise to those following the rise of certain technology giants. Earlier this year Apple became the first publicly traded company to eclipse $1 trillion in market capitalization.  Amazon, Google, and a few others are also experiencing strong price performance. As a result, broad US indexes like the S&P 500 are beginning to show signs of concentration from a size as well as a performance measure. As of the midpoint of 2018, the five largest stocks in the index were Apple, Amazon, Google, Microsoft, and Facebook[2] – all technology focused and accounting for 15.2% of the index.  Regarding 2018’s market performance, the big five technology stocks, along with Netflix and NVIDIA (also tech related stocks), account for approximately two-thirds of the S&P 500’s performance (as of October 3rd).  One must look back to June 2000 to find this type of concentration. At that time the top five stocks in the S&P 500 accounted for over 17% of the index.

Technology-focused companies are typically considered growth stocks, meaning they can be relatively expensive using traditional valuation metrics like price-to-earnings ratios.  Growth stocks tend to perform well when investors are optimistic about a company’s future earnings prospects. However, in some cases these stocks can draw investors more through a story than actual results.  This can be self-reinforcing at times as a stock viewed as having high potential growth can see strong returns over a short period of time, further raising interest in that stock and leading to higher and higher prices.  Steep price declines can result if the company cannot deliver on investor expectations, as witnessed by the “dot com” bust of 2000-2002.

To be clear, we are not suggesting today’s markets are on the brink of a technology bubble.  Market valuations, while somewhat above average, are nowhere near the high levels of the late 1990s.  Stock markets do not appear to be experiencing the euphoria of that era.  However, we are seeing signs of increased market concentration, investor interest in tech stocks, and the related questioning of the ongoing value of diversification. Historically, growth stocks have underperformed broad markets over longer periods of time. Thus, Empirical tends to avoid heavy exposure in this area.  As these stocks become more and more expensive on a relative fundamental basis, the likelihood of them underperforming in the future increases.  We recommend investors use caution when investing in this area of the market, particularly when looking at the recent winners.  Simply purchasing a small number of recent winners is not a sustainable investment strategy. We encourage investors to consider both adequate diversification and company/market fundamentals before making any investment decisions.

International Equity Markets

The prior section of the article discussed the importance of diversification within U.S. stocks. However, a more pressing question for many investors may relate to investing outside of the U.S.  The U.S. market is enjoying a nine-year run of strong performance relative to non-U.S. stocks.  Strong performance, coupled with familiarity of these companies and relatively strong U.S. economic data, may lead some to question the importance of non-U.S. investments.

Reliable performance data on international stocks can be found dating back to 1970.  Over the previous 48 years it is clear the relative performance of non-U.S. versus U.S. stocks are cyclical.  Our research, along with other leading firms, found differences in long-term performance between U.S. and international stock to be statistically insignificant. However, combining different regions into a globally diversified portfolio can reduce overall volatility.

Perhaps it is instructive to look at a historical comparison of U.S. and international stocks (see Figure 1 below) to more clearly appreciate the value of global diversification.  From 1970-1979, and again from 1980-1989, international stocks[3] outperformed the S&P 500 index.  This trend reversed in the 1990s as tech stocks fueled a U.S. rally.  International stocks experienced a resurgence in the 2000s, particularly in the period between the Tech Crash of 2000-2002 and the Financial Crisis of 2008.  From 2002 through 2007, the total performance of foreign stocks more than tripled that of domestic stocks.  Finally, since 2010, U.S. stocks have been among the strongest performing asset classes in the world, outpacing international stocks for the past nine years.

Figure 1: Market Performance by Decade
Time Period S&P 500 MCSI World ex-US [4]
1970-1979 5.86% 10.90%
1980-1989 17.55% 21.51%
1990-1999 18.21% 7.43%
2000-2009 -0.95% 2.04%
2010-2018 13.96% 5.82%

As Figure 2 shows, the difference in performance between U.S. and international stocks can be both significant yet cyclical.  While this divergent performance has historically proven to be unpredictable, it is highly unlikely this recent stretch of outperformance by U.S. stocks will continue indefinitely.  Investors can take advantage of the cyclical nature of these markets by diversifying their portfolio holdings.  Combining U.S. and non-U.S. stocks can create a portfolio that is less volatile than either region in isolation.  The Sharpe Ratio[5], a commonly used measure of risk-adjusted return, shows a blend of U.S. and international stocks offers a substantially better risk/reward tradeoff than either region alone. This is the free lunch, and why Empirical supports global diversification.

Figure 2: Market Statistics
Date Range (1970-2018) S&P 500 MCSI World ex-US MCSI World
Return 10.59% 9.44% 9.66%
Volatility 18.62% 16.77% 14.53%
Sharpe Ratio 0.57 0.56 0.66

Investing in both domestic and foreign equity will also position portfolios for a point when international stocks outperform, as they did in 2017.  International markets have become relatively cheap, given their recent bout of underperformance. Although prices and fundamentals are within long-term normal ranges, cheaper markets do tend to have higher long run return expectation than more expensive markets, all else being equal.

Investors concentrating in a small number of stocks, sectors, or even countries, may see periods of strong performance but they also greatly increase their likelihood of large losses. For example, Investors in the tech-heavy NASDAQ experienced a 74% decline from 2000-2002 and it took nearly 15 years to regain previous levels.  A globally diversified stock portfolio (i.e. the MSCI All-Country World Index), declined 47% over the same period but recovered in only six years. A properly diversified portfolio is among the most important investment decisions one can make when it comes to achieving investment goals while managing risk.



This newsletter is distributed for informational purposes only  and nothing herein constitutes an offer to sell or a solicitation of an offer to buy any security and nothing herein should be construed as such.  All investment strategies and investments involve risk of loss, including the possible loss of all amounts invested, and nothing herein should be construed as a guarantee of any specific outcome or profit.  While we have gathered the information presented herein from sources that we believe to be reliable, we cannot guarantee the accuracy or completeness of the information presented and the information presented should not be relied upon as such.  Any opinions expressed herein are our opinions and are current only as of the date of distribution are subject to change without notice.  We disclaim any obligation to provide revised opinions in the event of changed circumstances.

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. 

A copy of our current written disclosure statement discussing our advisory services and fees continues to remain available upon request.


[1] S&P 500 – is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices. In order to keep the S&P 500 Index consistent over time, it is adjusted to capture corporate actions which affect market capitalization, such as additional share issuance, dividends and restructuring events such as mergers or spin-offs

[2] Facebook has since fallen to 7th in the index due to negative performance over the past several months.

[3] As measured by the MSCI World ex-US Index

[4] MSCI World  –is an index that is designed to measure the equity market performance of developed markets, as used herein, it excludes the U.S.

[5] The Sharpe Ratio is calculated as (investment return – a risk-free interest rate)/Investment volatility.  For the sake of simplicity, the risk-free rate will be assumed to be 0% for this calculation.