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By Haywood Kelly, CFA | 08-03-98 | 12:00 AM | Email Article
Haywood Kelly, CFA, is vice president of equity research at Morningstar. He'd love to hear from you, and promises to read all your e-mail (even if he can't respond to it all).
The question comes up because of a little disagreement on our web site between two highly regarded investment theorists--Jack Bogle, the chairman of Vanguard, and Frank Armstrong, popular and articulate financial planner--about the merits of international diversification. Bogle argues that international investing has been oversold. "I don't think you need to go around the world to get good investment returns." And even if, statistically speaking, international stocks reduce a portfolio's standard deviation, "I've always thought a percentage-point increase in long-term return was priceless, and an increase in standard deviation was meaningless." Armstrong and others counter that investing overseas increases diversification, and thereby lowers risk--an inherently desirable outcome. According to Armstrong, Bogle is "dead wrong."

To appreciate what's at stake here, let's put the debate in the larger context of the question about diversification in general: Is it good? Is it bad? (It may come as a shock to some that anyone could possibly argue that diversification was bad.)

An analogy: When I was a senior in high school, everyone fretted about what college they'd get into, and agonized over the best application strategy. Some students filled out just a few applications, but worked long hours to make sure they were perfect: Neatly-typewritten forms, carefully-crafted essays--the whole bit. Other students took a different approach. They feverishly sent out applications to 10 or even 15 good colleges. With so many applications to complete, they lacked the time to ensure that every one was polished, but by spreading their bets around they hoped that some admissions officer, somewhere, would give them the nod.

Here's the parallel in the investing world. On the one hand are investors like Warren Buffett and Marty Whitman, who believe that focus is key to success. Research particular investments meticulously, they counsel, and when you find one you like, load up. If you know--really know--that an investment is great, there's little risk in devoting a huge chunk of your portfolio to it. Diversifying, in this view, just leads to shoddy work.

On the other hand are investors--including most financial planners and academics--who believe that diversification is the best, if not the only, way to reduce risk. The more efficient you think securities markets are, the more you'll lean toward this view. After all, if markets price stocks and bonds correctly, it's rather foolish to waste time looking for a few great investments. (Sadly, no one knows how efficient markets are; it's a tough proposition to test.) But no matter your view on market efficiency, you can still argue that widespread diversification is the best policy. The human ego being what it is, it's all too easy to convince ourselves that we're little Warren Buffetts, able to find great investments. Humility counsels us that no, we're not that good, and that we're better off hedging our bets through diversification.

Who's right? Well, the answer depends on the investor. Think back to the college applications. There's no right answer as to whether it's best to write a few, polished applications, or instead to mail out a dozen or more. For students who know where they want to go and can add value to their applications by spending time on them, the first option's better. For those who'd be happy at any of a number of good schools, and who can churn out quality work in mass, the second option's probably the best. Both sets of students may be pursuing their "highest-return, lowest-risk" option, given their desires and abilities.

Likewise in investing. Assuming an investor has the time and the knowledge to do research, it makes sense to focus on building a small portfolio of (potentially) great investments. Others may feel it's not worth the effort--or not even possible--and so choose to spread their investments far and wide, including internationally. And, of course, there's the whole range of positions in-between the two extremes.

Finally, back to Bogle and Armstrong. Bogle's argument is this: The U.S. market contains many great investment opportunities, so why dilute them by investing overseas? If he's right, and there are many great investment opportunities in the U.S., why indeed? Armstrong's retort: How do we know the U.S. contains great investment opportunities? What if the U.S. market tanks? Because we don't know for sure that these U.S. investments really are great opportunities, we need to spread our bets into other markets.

Neither position is "dead wrong." It all depends on how much confidence you have in those great U.S. investments. And that's something each investor must decide on their own.
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Haywood Kelly, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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