June 19, 2010

DIAmonds are forever

The Federal Reserve Bank of St. Louis just released the latest compilation of economic data from the G-7 countries and the Euro area. No great secrets have been revealed. Still, a set of charts comparing the historic performance of the major stock indices is worth taking a closer look in terms of how these markets are correlated.  Reason being, ever since the credit crisis, investors have been plagued by this question: “Should we still bother with diversification?” 

To answer a part of that question, I would like to re-quote from a source I have used before.  Douglas Short of  www.dshort.com  famously said:

“Diversification works – Until it doesn’t”.  And the proof is in the pudding as the chart shows. 


Reviewing the latest update from the Fed of St. Louis research comparing the stock indices of various countries, we can see that the trend towards higher correlation did not just start in 2007. Ever since the European Union countries worked on aligning their economic policies in the run-up to their single currency, the major European markets moved essentially in tandem. 


Examining a few other G7 countries, their stock markets also showed a relatively high correlation especially since the burst of the internet bubble. 


Then 2007 came along, and as we saw in the first chart, there was simply no place to hide during the credit crisis, hence the run for the exit move into cash and short-term Treasuries. In the face of all this then, the main tenets of Modern Portfolio Theory need at least some refinement.  But that is something institutional and high net worth investors should undertake.  In terms of giving a typical stock portfolio for the average investor a good amount of international diversification, I have a slightly more controversial but certainly much easier to implement proposition:

First, re-examine what your traditional advisor might have told you for a moment.  Most advisors and planners generally suggest an international portfolio allocation based on a tick box approach where your answers to their risk and customer questionnaires are massaged by some black box metrics and an appropriate allocation is then suggested.  Your typical planner will put you into one of 5-6 pigeonholes from conservative to aggressive investor. Hence, your international component might be anywhere from 0% – 25% depending on which allocation model is chosen and obviously how you answer their questions.  A lot of that tick box approach is highly questionably to begin with and in the face of the higher inter-connectedness of all markets, unnecessary to a certain extent.  It also makes, managing your portfolio a lot more difficult and expensive (remember a planner also has to justify his fees). 

Instead of the usual Spiel, consider DIAmonds. In other words, consider investing your entire stock portfolio with only one major market index such as the Exchange Traded Fund SPDR DIAMONDS TRUST (DIA) which matches the index components of the Dow Jones Industrial Average. Then forget about any additional international diversification completely. 

Here's why...

Looking at the list of the 30 Dow components, there may be just a handful of companies with limited or no international exposure. 


The vast majority of the Dow component stocks however, derive a substantial part of their income from outside the US.  So why bother trying to fine tune your international exposure correctly.  Let the companies determine that allocation.  After all, successful companies will go to those countries where they can achieve the best returns on their assets.  Just follow their lead and take advantage of the built-in international exposure that comes from the large number of multi-national component stocks in the Dow.  Warren Buffet once said: "My preferred holding period of a stock is forever". 

With a traditional dollar-cost averaging method, buying a fixed dollar amount of DIA shares each year, DIAmonds are ideally suited to fit that bill.  After all, DIAmonds are forever...

Afterword: There are various other Indices and other ETFs one can consider in bringing some international exposure to a stock portfolio.  DIA is used as an example because of its relatively small number of holdings, making it easier to understand what the ETF is actually comprised of, something that is getting increasingly difficult with some of the more recent ETFs.  DIA also has a low expense ratio of 0.18% and no built-in incentives for financial advisors to earn commissions. That is why these types of low-cost funds are typically more attractive to the investor rather than the broker or financial advisor. There are certain risks when purchasing any security including ETFs.  As always, know what you are buying and remember to read the prospectus before considering an investment in any ETF or Mutual Fund.  For the purpose of this article, international diversification via currencies is not discussed here. Please contact to receive some information on how to include currencies in your portfolio.  You can also click on the following Labels to read prior FXIS articles about currencies:  Currencies, US Dollar, Euro, Australian $, Canadian $, Swiss Franc and Japanese Yen

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