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September 18, 2013

Global Diversification is the “Only Free Lunch that Really Exists”

Alan Moore, founder of Serenity Financial Consulting, LLP, says that if there’s anything risky about international investing, it’s not doing it as part of portfolio diversification.

An academic background and a master’s degree in financial planning taught him a lot about modern portfolio theory, among other things. “[MPT is] the first time anybody ever suggested that diversification is a good thing,” he said, and global diversification is not only part of that theory, not doing it doesn’t seem reasonable. In fact, it’s the “only free lunch that really exists.”

What does Moore mean by that? That “different asset classes and countries, across different industries and sectors, either will increase client return or decrease risk for the same amount of return.” It just doesn’t make sense, he says, not to do it, particularly when you consider how risky investing only in the U.S. can be. “Sequesters, the debt ceiling crisis—the U.S. market can really take a hit. I don’t want [to invest for clients] based solely on what the U.S. is doing,” he said.

Moore’s client portfolios are invested roughly 50/50: about half in the U.S. and about half elsewhere, with the bulk of the elsewhere going into developed markets but with emerging markets also making up part of the allocation. He relies on mutual funds to provide international diversification for client accounts, rather than buying individual equities or seeking out particular country weightings. That provides “exposure to about 20,000 different companies, which is about as diversified as I know how to get,” he said.

Moore looks for investment managers that “buy the market basket,” so that each client’s portfolio has about the same exposure to those 20,000 or so stocks across the globe and also has a “pretty low” expense ratio. He also said he regularly rebalances client portfolios, so that when one sector outperforms, its gains are harvested. That presents opportunities to lock in profits and buy undervalued sectors. “That ability to rebalance is huge, and having those international stocks increases our ability to do that,” he said.

Moore has been doing international investing since he started as a planner, even before he founded his firm, both for himself and for his clients. He believes that “markets are largely efficient and stock prices are set appropriately, and it’s impossible to beat the market,” so he uses passive investing, does not try to time the market and is happy to rely on those mutual fund managers to provide the diversification he seeks—though he does say that a bit more exposure to China would not come amiss because it represents such a large portion of the world’s wealth. Its markets being what they are, making access difficult, he says that sometimes clients are a bit underweighted in China.

That said, Moore said that his investment strategy is not about favoring any country. Instead, it’s “about having your rationale, having your plan and reasons for the plan, and sticking to it.” Financial planning is as much art as it is science, he says, with no single right way to do it, and “there’s no perfect percentage in anything. It comes down to a lot of personal opinion.”

As a result, “What I don’t want is to be guessing. Because that’s all it is. If I say Japan’s going to do really well because they’ve had 20 years of deflation, that’s a guess. It’s playing roulette with clients’ money, and that’s not a position I want to be in.” It’s taking more risk than needed, he says, and thinks that sometimes people do that because they “have to excuse their investment management fees,” he said.

While Moore said that the first question a new client asks is often “Aren’t international investments risky?” when he tells them about the 50/50 strategy, he said they’re fine with it once he’s explained that the U.S. only makes up roughly half of the world’s stock market wealth and that “by keeping more than 50% of investments in the U.S., we [would be] betting that the U.S. will outperform the rest of the world long term. While this is certainly possible, it is also possible that the rest of the world will outperform the U.S. I do not want to make a bet on which one will happen.”

People have been told for a long time that international investing is risky and that U.S. stocks are safer. “The good thing about the market downturn is that folks realized that U.S. stocks are risky too. You’re owning stocks of companies that may fail,” Moore said. Clients are also often surprised to learn that the U.S. does not dominate the financial scene the way it once did. The growth of emerging market economies, such as China, has meant that the rest of the world’s financial markets are more important than they used to be, he said.

In fact, the emerging markets—Central and South America and parts of Europe included—have done “phenomenally well,” although of course he hastens to add that they also carry more risk, he said. But it’s his job to educate clients about such things. He doesn’t work with clients who are so bound up in the minutiae of stocks that they lose sight of the bigger picture.

“Although they have input, they don’t say to me, ‘Ten percent of Europe is too much; we should be at eight.’” Instead, they trust Moore and his strategy, and seem to be enjoying that free lunch.

 

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