Is it Diversity or Mirage?

I’m always getting into pissing contests over foreign investment. It just points out how much of bogglehead land is steeped in mythology and dogma. Foreign investment is best characterized by the BH3 the three fund that holds 20% bonds 30% foreign and 50% US. The argument goes somehow owning foreign pays you compared to not owning foreign. Somehow owning foreign improves your “diversity”. If that’s the case there should be metrics to support that. Let’s consider Japan. Japan is a well run economy the 3rd largest in the world.

Here is the Niekki 225 dting back to 1970

And here is a S&P 500 chart dating back to 1950 but including a similar period as above

In the 80’s foreign was the hot topic, especially Japan. You threw some money at Japan and it threw more money back at you, multiples of more money. It was almost as good as buying AMZN in 1997. Then came 1990 and the party was over. Japan deflated. It’s now 30 years later and Japan is still deflated. In my opinion the loss is permanent, at least for anybody relying on Japan to pay them in retirement. If you retired in 1990 with 50% of your dough in Japan and a 4% so called “SAFE” WR you ran out of money decades ago. The contrast is the USA. It’s trajectory is up at a greater rate than 4%. Over 30 years the S&P has grown at 10+% per year and 4% even with a bad SOR is overcome by the monster 10% return. This is the reason 4% is “Safe”. This and no other reason. The reason the S&P grows like that is because US productivity rages at about 4% long term and productivity is the furnace that keeps the balloon inflated. There is nothing inherent in our economy that guarantees 4% productivity. In may respects it’s because we lucked out historically and benefited immensely from creative destruction.

I once owned stock in a Russian mining company. Big company with big profits and superb growth. I was so pleased with that ownership, I dutifully checked it every day. Mining is a big deal in Russia. Russia for example is the second producer of gold in the world along with things like cobalt nickel copper iron etc. One day Putin indited the oligarch prez/major shareholder of this mining company. In addition Putin suggested taxes be placed on this company I owned! The stock plummeted. Without it’s head and with the threat of monster taxes the stock deflated like the Nikkei. Putin was short the stock. I had a Russian partner in my practice and he filled me in on the reality. Being short means you sell high and then buy low at a later date and pocket the difference same as with profit on a long trade. By arresting the head of the company and threatening taxes Putin pocketed billions. As well, he then owned the stock, bought low, and owning the stock was equivalent to owning the gold mines that constituted the property of that company. Just because the stock price fell didn’t change the worth of the underlying property. Putin has a plan to put the world back on the gold standard, and remove the US as the reserve currency. If you make gold the reserve and you own all the gold, you do the math.

This is why foreign is problematic. We live in a bath where the water temp is always fine and sustaining, and we stupidly presume the water elsewhere is equally as pristine so we “diversify” in our doe eyed stupidity.

Here is a graph of the BH3 Efficient Frontier plane with the BH3 described by the point Provided Porfolio.

The global fund is WAY low and right with a piddly 7% return and near 18% risk

Here is US Stocks 11.3% return at 15% risk. 4+% better return with 3% less risk.

Here is the BH3 R/R

8.9% at 12% risk

Here is a Efficient Frontier 2 fund with a 12% risk AND 10.11% return. 1.2% better return for the same risk. If you do the math that 1.2% advantage of the 2 fund over 30 years is a 38% improvement in end portfolio value compared to the BH3. 38% is a lot of money to pay just to wear the badge “diversity”.

Don’t even get me started on the BH4 fund! The BH4 adds TIPS to the BH3 mix. It’s long term return is 6.57% at 12.3% risk MORE RISK LESS RETURN!. Just goes to show you can make a bad thing even worse no problemo.

Take away:

  • Deflation is a real thing
  • Foreign is quite open to manipulation and permanent losses
  • Rule of law matters
  • Productivity and protection of productivity is paramount
  • Diversity does not mean “just own everything” and you’ll be safe. It means own the right things and do the right things and you’ll be safer. The right things are easily discernible.

8 Replies to “Is it Diversity or Mirage?”

  1. Well I for one would not argue. That’s because I really am not sure what the right way is especially as a Canadian.

    All I focus on is developing resilience with modest spending. I invest in multiple arenas with liquid assets to provide financial agility.

    And reaching FI allowed for Optionality. Whether or not I trigger it fully is debatable.

    What you display is confidence in your plan. But I see you have built in many levels of safety for your family. That’s likely more important in the bigger picture.

    1. Risk is the exact point. There is no excess return without risk, PERIOD. FIRE is almost exclusively built on narratives based return, analysis of risk be damned, yet EVERY point on that risk return plane has both risk and return ordinates. If you pay for your return with too much risk, in the end you likely made a bad deal unless you got lucky. Let’s say you buy an apple from the same bin every day. You can pay $1 or $2. You get to choose. The only difference is the second choice makes your wallet thinner over decades because over decades you paid twice as much for your damn apple habit. You pay $2 because you read in a Taylor Larimore book $2 apples are “safer”. Welcome to the land of narrative. Risk is risk whether you pay $1 or $2 because it’s the same apple you are buying. This is why the bucket theory is a crock and paying off your low interest loans before investing in higher returns is a crock. With bucket theory you keep diluting your return while maintaining your risk and in loan repayment you spend all our money to “feel good” instead of spending your money on compounding. Part of the problem is an actual misunderstanding of what constitutes diversity. Basically there is stocks bonds debt commodities and real property these are the things you can invest in. Foreign stocks and US stocks are STOCKS. The correlation between foreign and US on the way up the growth curve is about 90%. On the way up foreign can buy you a tiny bit of diversity. We saw that with the run up in 2018 foreign did somewhat better than US and US did great! What about 2018? US did bad but foreign did horrible, way worse than US. So the little dab of diversity you gained in 2017 was erased and you lost money to boot compared to US. In 2008 US went down like 45% but foreign went down 70%. That means to get back to zero for US you need to make back 90% but for foreign you need to make back 140%. This is why Japan never recovered. Once deflation started in 1990 the productivity was not enough to overcome the deflation and people put their money elsewhere, like the USA so their deflation became part of our inflation. Bonds have a near zero correlation with stocks. When stocks go up and down bond don’t care. They just keep bonding their way along. There is a market in bonds but it doesn’t go up or down with stocks. There is commodities. Some commodities also tend to be independent or negatively correlated with stocks. Very often when stocks boom commodities like copper boom because construction booms, but commodities like gold wane because people put their money in stocks rather than gold. Gold shines when the market busts and people retreat to safety. Real property tend to lag stocks and correlate about 50% with either stocks or bonds. So stocks can boom and then real estate will boom a couple years later, or interest rates will rise and real estate will crash. The problem with real estate is the risk is huge for the relative return. US Stocks have a 10% return and a 15% risk, whereas REITS have a 11% return and a almost 20% risk.

      Since the risk and return of a given portfolio is based on the geometric sums of the individual components taking into account the risk, return, and correlation of each asset buying riskier stuff without out-sized return hoses the portfolio in the long run like paying $2 for a $1 apple. I can’t speak to the Canadian perspective because it’s hard enough to just hang onto the American perspective without loosing my mind. Add currency inefficiencies and different tax law and different economies trade tariffs etc and the eyes cross.

  2. I have to admit before I read your teaching on the subject I went with the flow and followed the Bogleheads creating my portfolio.

    I have a question, is the efficient frontier graph provided by Personal Capital similar to the above examples? Currently my asset allocation is 55% domestic, 20% International, 15% REIT, 5% Bonds (I know a bit oddball) but it puts me smack dab on the efficient frontier and even slightly better than the Personal Capital suggestion. (according to PC I am 8.6% return, 13.3% historical risk ( what is suggested for Growth model of PC would be 8.6/13.6%). Of course these numbers are still not as good as the model you provided.

    1. I just checked Personal Capital My risk is 10.3 and my return is 7.5 but I’m overweight in cash compared to the suggested 10.3 risk and 7.7 return estimated by their AA. I’m over weight in cash for Roth conversion reasons so there is a specific reason to be overweight. I do have some foreign but less than recommended and more US than recommended. I have less alternatives than recommended but I lightened up on alternatives when it looked like we were heading for a crash, plus due to Roth conversion, so My AA is a bit dynamic right now. I sold my real estate because I don’t like the risk. As I spend down the cash my AA will improve and I will be 5 years closer to death so my portfolio’s need to survive will be reduced. My predicted sustainability is 99% with the present allocations and will improve slightly with correcting my AA to precisely match the EF. The bogglehead portfolio is not horrible. It’s just NOT the “man’s best portfolio” its adherents pretend it to be. Because of the excess risk you leave money on the table and increase the probability of failure aka pay me $2 for a $1 apple

      1. Thanks for the evaluation. I was happy to be pretty much on the efficient frontier (again only using personal Capital) but it does look like there is room for improvement like the model you provided based on 2 asset classes

  3. I have a similar question to Xrayvsn’s; it seems like whenever I add a third variable on the modeling website that you use, it pulls it off the efficient frontier. I’m wondering then how Personal Capital is coming up with their frontier calculations (e.g. for an ‘aggressive’ portfolio for me it suggests ~60% domestic equities, ~20% foreign equities, 10% bonds and 10% ‘alternatives’). You would think with foreign equity pulling so hard to the right that would be impossible.

    Interested in your thoughts; I’m sure there are some fundamentals I’m missing as well.

    1. Use asset classes and not tickers as an example. Choose dual EF. Add US total stocks US total bonds and Gold and REITS to the asset mix. Tick all 4 for 1 curve and US stocks/US bonds for curve 2 and generate the curves. If you move up curve 2 to a 40% bond allocation (39.39) you see anticipated 8.49 return and 9.10 risk. If you compare to 40% bonds on curve 1 the return is 8.37 for 8.32 risk. 1.4% less return for curve 1 assets BUT nearly 10% less risk than curve 2 assets. If you look at the correlations STOCK BOND GOLD and REIT are very uncorrelated and this is the actual meaning of diversity. So in owning curve 1 assets you are more diversified and your portfolio has lower risk.

      Next move up curve 1 to a point where risk is basically equal to 9.1. I chose 9.2. In this case for a 1% increase in risk you generate 3.2% more return. The added return is called the free money of diversity. You then look back to what the curve 1 asset mix gives you the return and risk you desire. I’m not sure how Personal Capital calculator works under the hood in terms of optimization except I do know my portfolio mix is very different than their recommended but my efficient frontier position is dead nuts on.

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