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By Noah Solomon
Special to the Financial Independence Hub
Harry Markowitz, recipient of both the 1990 Nobel Memorial Prize in Economic Sciences and the 1989 John von Neumann Theory Prize, referred to diversification as “the only free lunch in finance.”
As most investors are aware, diversification is an essential element of any well-constructed portfolio. Diversification across different markets and individual securities can lower volatility, mitigate losses in declining markets and produce higher risk-adjusted returns over the long-term.
Easier said than done: the temptation to chase returns
Of course, during times when one asset class or country outperforms for an extended period, this can lead to feelings of regret. Looking in their rear-view mirrors, investors often wish that they had been less diversified and had an overweight position in the outperforming asset class. This regret can result in FOMO (fear of missing out), whereby investors pour capital into those areas of the markets which have been outperforming.
The U.S. stands alone
Since the post-financial crisis market bottom of March 2009, the U.S. stock market has dwarfed those of other markets in terms of performance. U.S. stocks have produced almost double the return of emerging markets stocks, which have been the second-best performer.
| Country | Annualized Return | Cumulative Return |
| U.S. | 15.1% | 381% |
| Emerging Markets | 7.5% | 199% |
| Europe | 6.9% | 189% |
| U.K. | 6.1% | 176% |
| Japan | 5.7% | 170% |
| Canada | 4.9% | 157% |
Sources: MSCI, Factset Research Systems
Unsurprisingly, the outperformance of U.S. stocks, reflected in the table below, indicates that the U.S. market currently stands as the most richly valued market as measured by its cyclically-adjusted Price/Earnings Ratio (CAPE).
| Country | Cyclically Adjusted P/E (CAPE) |
| U.S. | 32.1 |
| Japan | 27.2 |
| Canada | 22.0 |
| Europe | 19.4 |
| U.K. | 16.9 |
| Emerging Markets | 16.4 |
Source: www.starcapital.de
Punished for doing the right thing
The spectacular outperformance of the U.S. stock market means that portfolios that have been heavily concentrated in U.S. stocks have generated considerably higher returns than their more diversified counterparts. In other words, investors who have sacrificed diversification in favour of being overweight U.S. stocks have been handsomely rewarded.
However, historical patterns suggest that the benefits of diversification will prevail, and that now is an opportune time for long-term investors who have been heavily concentrated in U.S stocks to rebalance their portfolios.
Mean Reversion: a powerful force
In a 1997 research paper published by the International Monetary Fund called Winner-Loser Reversals in National Stock Market Indices: Can They be Explained, author Anthony Richards documents clear evidence that markets tend to mean revert over time in terms of relative performance. Markets that have exhibited above average performance for several years tend to deliver subpar returns over the next several years, and vice-versa. The practical implication of this pattern is that investors who systematically overweight markets that have outperformed tend to generate below average returns over the long-term.
Stick with the program
Strict adherence to the principles of diversification will serve investors well over the next several years as mean reversion runs its course and globally-focused portfolios outperform their U.S.-centric counterparts.
As CIO and President of Outcome Wealth Management, Noah Solomon has 20 years of experience in institutional investing. From 2008 to 2016, Noah was CEO and CIO of GenFund Management Inc. (formerly GenuityFund Management), where he designed and managed data-driven, statistically-based equity funds. Between 2002 and 2008, Noah was a proprietary trader in the equities division of Goldman Sachs. Prior to joining Goldman, Noah worked at Citibank and Lehman Brothers. Noah holds an MBA from the Wharton School of Business at the University of Pennsylvania.
