There are a few simple things that will massively improve the financial performance of most portfolios over time:
- Most investors do not have the ability to outperform the financial markets (often called having an “edge”), so as a result, they should invest in index-tracking products. In my recent book, Investing Demystified, I call such people “rational investors.”
- By keeping trading to a minimum and investing efficiently with the lowest possible fees, investment portfolios will perform far better in the long run.
- To have some hope of respectable long-term financial returns, the portfolio should probably have some equity exposure to avoid the dull returns that safe bonds or cash in the bank currently provide.
But Which Equities Should Most Investors Own?
I believe the only equity exposure that people who agree with the points above should have is in the cheapest, broadest, most tax-efficient index tracker of aggregate world equity markets they can find.
Why? Let’s assume that from the perspective of the rational investor (an investor accepting and embracing the fact that she doesn't have an edge in the market), each dollar/pound/euro/etc. invested in the stock markets around the world is presumed equally smart.
So while the markets may say a share in Apple is worth $125 and a share in Microsoft is worth $44, we as rational investors do not have a preference for investing an equivalent dollar amount in either company. If we did have a preference, we would effectively be saying that we know more about the future movements in share prices than the aggregate market does, which we, as rational investors, do not.
Therefore, we believe the person buying Apple is no more or less clever/informed than someone buying Microsoft. Applying this logic to the whole market means that we should own shares in all the stocks in the market according to their fraction of the overall value of the market. So if, for example, we assume that the market refers only to the US stock market and that Apple shares represent 3% of the overall value, then 3% of our equity holdings should be Apple shares.
If we do anything other than this, we are somehow saying that we are more clever and more informed — that we have an advantage over the other investors in the market.
Massive Diversification Is Possible — and a Wonderful Opportunity
Thanks to the many index-tracking products now available, buying equity in hundreds of firms on the US stock exchanges in proportion to their respective market capitalizations is much simpler today than it was a generation ago. (In the example above, Apple would constitute 3% of the value of the index tracker.)
But why stop at the US market? If there is $15 trillion invested in the US stock market and $2 trillion in the UK market, there is no reason to think that the latter market is any less informed or efficient than the former — likewise with any other market in the world that investors can get access to. We should invest in them all, in the proportions of their share of the world equity markets within the bounds of practicality.
If you were able to over- or underweight one country compared with its fraction of the world equity markets, you would effectively be saying that a dollar invested in an underweight country is less clever or informed than a dollar invested in the country that you allocate more to. You would essentially be claiming to see an advantage from allocating differently from how the multi-trillion-dollar international financial markets have allocated — which, without some sort of edge, you are not in a position to do.
In addition to it being much simpler and cheaper, since investors have already moved capital between various international markets efficiently, the international equity portfolio is the best one.
Take me as an example. As a Danish citizen who has lived in the United States and the United Kingdom for 20-plus years, I might instinctively be over-allocating to Europe and the United States because I am familiar with those markets. But in doing that, I would implicitly be claiming that Europe and the United States have better risk/return profiles than the rest of the world.
That may or may not be true, but the point is that we do not know ahead of time. You may find yourself making statements like “I believe the BRIC [Brazil, Russia, India, and China] countries are set to dominate growth over the next decade and are cheap." You may be right, but you would also be saying that you know something that the rest of the world has not yet discovered.
This does not make sense unless you have an edge.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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