Recently one of my friends posted a fascinating slide created by none other than Warren Buffet. The slide showed the 20 largest companies in the world right now, as measured by market capitalization. Then he showed the 20 largest companies in 1989.
Want to know how many of the world’s largest companies in 1989 are still among the top 20 today? The correct answer, believe it or not, is zero. None.
This is a simple example that helps explain a complex truth about investing. The complex truth is that, even though small and value stocks are riskier than large stocks and the stocks of well-known companies, diversifying your portfolio with these riskier small stocks makes the whole portfolio less risky.
The same truth holds when talking about international stocks, including stocks from emerging markets. International stocks are riskier than US stocks, but including them in your portfolio makes the whole portfolio less risky.
Remember that list of the top twenty companies in 1989? A big part of the reason that so few of those companies are still on top today was Japan. 1989 was the peak of the Japanese stock market bubble. Not only were the majority of the biggest companies in the world Japanese, but six of the top twenty companies in 1989 were Japanese banks.
In Japan at that time it was fashionable to ignore advice to diversify. (The same thing happened in the US in the late 1990’s and it is happening again now). But Japanese investors who kept all their money in their familiar, “safe” home country’s stock market paid a price. The stock market declined by 80 percent. To this day, a Japanese investor investing in Yen, who started in December of 1989, with all dividends reinvested and accounting for inflation, would still be just barely underwater. Still. After over three decades. That’s a long, long time to have a near-zero return on money invested.
But here’s what’s interesting. Even in Yen, a Japanese investor would have made plenty of money with a global portfolio. Here’s what’s even more interesting. Even a Japanese investor who stuck with their own country’s stocks but created a portfolio of small and value stocks would have made money. The returns would not have been incredible, but they would have been good.
There are two powerful lessons here that no investor should ever forget. Lesson number one: Big companies don’t always stay big. Lesson number two: The world does not stay the same.
Because big companies don’t always stay big and because the world changes in unpredictable ways, anyone invested in stocks should diversify globally and diversify with small and value. Investors, particularly retirees, should not just put all their money into large, familiar, “safe” stocks from their home country.
But particularly for retirees, why bother with stocks at all if stocks are so risky?
Well first, most investors need some growth. And second, sometimes the financial world itself turns “upside down.” Most of the time, stocks are riskier than bonds and bank accounts. Stocks are not just pieces of paper. They represent ownership in companies. So stocks are risky because companies often do poorly precisely when the economy is doing poorly.
But when true catastrophe strikes, that equation sometimes gets turned upside down. The reason is that companies will always be worth something, even in the worst case scenario. That isn’t true of bonds or currency. When inflation spirals out of control, bond interest rates don’t keep up and money in the bank can quickly become worthless.
Countries like Zimbabwe, Venezuela, and Brazil provide examples. These countries all experienced hyperinflation. The currencies became worth very little and bonds failed. But each country’s stock market survived. In fact, in places that experience hyperinflation, it usually happens that stocks eventually get seen as the only “safe” investment, other than investments in physical goods and property.
Everyone should invest at least some of their money in a global stock portfolio. Now 401(k) plans and similar defined-contribution plans have done a pretty good job of getting most people used to investing. But they have not always done a great job of helping people diversify properly or make good decisions about how much risk they should take.
When it comes to diversification, always remember that it’s easy to see that a bubble has formed, but it’s nearly impossible to know when it’s going to burst. It’s easy to tell that the world is going to change, but it’s nearly impossible to know how it will change. Today’s winners are often tomorrow’s losers, so the investors who win in the long run are the ones who invest in such a way that they don’t need to care who those winners and losers are.