We recently received the following question:

I read on your website you recommend holding assets in things like lumber, oil, or gold, as well as foreign investments. If these funds traditionally have lower returns than US stocks what is the justification for having these investments?

There are really two questions here.

First, why invest in anything other than U.S. stocks? And second, why would you ever invest in something that has lower returns?

Both of these are common misunderstandings.

Some advisors have a strong bias towards investing in their home country. For here, that means a strong bias towards investing in only the United States. However, diversification among many different countries provides a more consistent return than investing entirely in the United States. The same benefits that arise from other portfolio diversification are there for global diversification.

I once overheard investment advisors talking to one another in a hallway at a conference. They were discussing foreign stock allocations. They were expressing fear of investing abroad, saying, “Any time we allocate less than 50% to the U.S. we are betting against the U.S. and better have a real good reason.”

There is always a familiarity bias among investors. The questioning of the familiarity bias never ends: Why invest in Sweden when you could invest in the United States? Why invest in Atmos Energy Corporation (small cap) when you could invest in Microsoft Corporation (large cap)? Why invest in Australia when you could invest in the United Kingdom?

Investors have been told, “Invest in what you know.” While this may have been a good adage for avoiding investing in companies with no business models, it is a poor rule of thumb to use when building diversified portfolios.

Because of a familiarity bias, most investors have over-weighted large cap stocks whose names they recognize and whose products they use. This large cap bias occurs despite the fact that mid cap and small cap, on average, provide a higher rate of return over time.

Even in the realm of large cap stocks, investors most often invest in companies that are well-respected and considered to be the best in their field. This happens despite the fact that studies have shown that these industry leaders, on average, under-perform companies whose stock prices are temporarily depressed because the companies are having trouble.

Because investors concentrate their investments in what they are familiar with, they often don’t even know that they are concentrated. We have seen investors who thought they were diversified because they were invested in several mutual funds with different names while each funds held similar underlying investments.

Studies have shown that when investors are given several choices, they tend to put an equal portion in each investment option. This is known as diversification errors. Since many 401(k) plans don’t have the same number of funds representing each asset class, naïve investors often build very unbalanced portfolios.

Instead of biasing yourself towards what is familiar and making that your default, you should bias yourself towards everything. Assume by default that you are going to invest in every single company in the world (which you can actually do with an All World Total Stock fund). Then ask yourself why you might benefit from giving weight to particular sectors and pulling away from others.

It is the task of investment analysts, like ourselves, to identify factors which outperform the market. Many have been found by many talented analysts.

For over a decade, we’ve been advocating freedom investing, the idea that investing in countries rated high in economic freedom should produce better returns than investing in countries with more controlled or repressed economies.

Every year the Heritage Foundation evaluates all the world’s countries using their Index of Economic Freedom, where a high score correlates to nearly every positive measure of a country. We then use this analysis to craft our Foreign Stock investment strategy that we call “Freedom Investing.” Then, we use efficient frontier analysis to determine appropriate sector allocations.

In addition to the countries high in economic freedom, we have an allocation to emerging markets. Over the past three decades, the correlation between the S&P 500 and emerging markets has been a low 0.53. Low correlation between volatile assets produces the biggest rebalancing bonus. The rebalancing bonus to portfolio returns of blending emerging markets into an otherwise all U.S. portfolio might be as high as 0.33% or 0.35%.

When it comes to U.S. stocks, not everything is on the efficient frontier. It seems that small-cap growth has both higher volatility and lower returns than every other style-box category. Whatever the reason, we reduce allocations to small-cap growth. On average, this move should boost returns and lower volatility.

We tilt small and value, including a healthy allocation to mid-cap value for downside protection, in a strategy called “Value Investing.”

Resource stocks, sometimes called “Hard Asset Stocks,” include companies that own and produce an underlying natural resource such as oil, natural gas, precious metals, base metals such as copper and nickel, coal, or even lumber. They can provide protection against inflation because their largest expenses are the purchase of extraction rights. Inflation then can’t meaningfully increase the cost of production until extraction rights expire because they’re purchased only once for a long period of time. Real estate investment trusts (REITs) are resource stocks for the same reason – their expenses were paid up front with the purchase of property and don’t inflate unless you buy more property while rental rates can increase with inflation.

Investing in resource stocks is not the same thing as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment directly in raw commodities and their volatility. The optimum asset allocation to physical gold and silver is 0% since the average return is just inflation whereas the expected standard deviation (risk) is very high. A gold mining company’s profits behave differently, making it a resource stock investment.

We segment resource stocks into their own asset class because they have a unique set of characteristics. First, the movement of resource stocks is generally less correlated with the movement of other asset classes. Second, resource stocks have a unique (and positive) reaction to inflationary pressures. And third, there are periods in the longer term economic cycle when including resource stocks helps boost returns.

The beauty of resource stocks is the fact that they are not highly correlated to U.S. large cap stocks as a whole. Low correlation between volatile assets produces the biggest rebalancing bonus.

Furthermore, the correlation between resource stocks and bonds is even lower and may even be negative. A negative correlation means that bonds and natural resource stocks, as separate asset classes, are often moving in opposite directions. Balancing a bond portfolio with resource stocks can help hedge the risk inflation poses to a bond portfolio.

For this reason, we recommend the resource stocks sectors of energy, U.S. REIT, and foreign REIT.

All of these strategies, we justify with factor analysis and historical returns. Now, the markets are inherently volatile. There are decades where U.S. Stock is the reigning champion, and there are decades where it is the worst loser.

Rather than using this evidence to either tilt towards or away from U.S. Stock, I would use it as justification for why diversification into other countries or sectors has a good chance of boosting your returns.

In month to month snapshots, diversification dampens both the highs and the lows. You always have an investment to complain about and an investment that is your darling. But the goal isn’t to invest only in what goes up. The goal is to support your financial needs, which is why your portfolio needs diversification.

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