This is part two of a two part series on passive investing. Part one is "An Introduction to Passive Investing" (see article).

The Case for Global Diversification

Investing solely in a globally diversified index fund removes practically all active investment decision making. It's the most passive of passive investing strategies (see article).

The only decision you'll ever have to make as an investor is the decision on which globally diversified fund you invest your funds. This choice should be simple. It should be the most diversified global index fund, with the lowest fees and tracking error.

This investment strategy ensures you remove almost all elements of bias when selecting the fund to invest in, and you'll also be well-diversified. Passive investors who do not invest in globally diversified funds remain exposed to significant risks.

As an example, assuming you're invested solely in an S&P 500 fund, you're betting on the US economy over the global economy, with all your eggs in one basket - the US economy. It follows that your returns are to be determined by the growth and success of the American economy.

Since the 2008/2009 financial crisis, investing in an S&P 500 fund would not have been a bad bet as the US economy had been very strong. It has resulted in the SNP 500 having an annual growth rate of around 12% as the S&P 500 correlates highly with the US economy. However, the past does not determine the future and who's to say that the historical growth rate will continue indefinitely?

Similarly, you're putting all your eggs in one basket if you invest solely in a FTSE 100 index fund or a Nikkei 225 index fund. You're betting on the UK or Japanese economy to outstrip the growth of the global economy. By deciding to invest in a geographical index, you are making an active decision. Inexperienced investors should avoid making any active decisions.

Even if you invest in a combination of indices, although you're better diversified, you still implicitly believe the combination of indices making up your portfolio will generate greater returns than a globally diversified fund.

The Risk of Investing in a Single Index

Although investing in an index diversifies your risk across all companies within that index, you're still investing in a single index. Betting on a single index can be risky.

Just look at what happened to Japan's index the Nikkei 225 in the late '80s. It reached an all time high of 38,916 on 29th December 1989 but has since spectacularly crashed and has not been able to recover to anywhere near its all time high in 30+ years. At the time of writing, the Nikkei 225 is 21,746. Investors have lost billions during this period.

Nikkei 225 Index. Source: macrotrends.net

Given the possibility that this could happen to any index, be it the FTSE 100, Nikkei 225 or the SNP 500. It could also happen to an industry-specific index such as the MSCI World Information Technology Index or a market capitalisation index like the FTSE Global Small Cap Index.

Although investing in a single index is less risky, it is still risky business. It would be wise to diversify even further and reduce the risk of investing in a single index, by investing in a globally diversified fund.

Advantages to a Globally Diversified Index Fund

By investing in a globally diversified fund, your portfolio is better diversified across a range of markets, industries and company size. Broadly, your returns correlate with the rate of growth in the global economy.

The strategy of investing in a globally diversified fund epitomises the passive investing strategy. Having all your assets invested in just one fund, makes it a true set and forget strategy. You only ever need to remain invested in a single fund.

Things like asset allocation, diversification and rebalancing and active monitoring of your portfolio are all being handled for you by the fund manager. Well, more likely a computer, with oversight by the fund manager. You never need to worry about your investments and your savings can entirely be automated.

Should you wish to reduce your risk even further, you may want to introduce a globally diversified bond fund into your portfolio.

Unless your net worth is in the multiple millions, you should not be investing in other asset classes, such as commodities or precious metals. These should not be included within simple, everyday portfolios.

Investing in a globally diversified fund ensures you own all the largest and significant companies across the globe. These companies operate in pretty much all industries, from fast-growing tech companies to construction and consumer goods. Whenever a company becomes significant enough, you'll own it through the fund, who would have purchased its shares.

As such, a globally diversified fund epitomises capitalism. You own a share of all large and significant companies across the globe. If you believe in the future of capitalism, the globally diversified fund is the way to go.

Providing the global economy is larger in 30, 40 or 50 years than it is today, a passive investing strategy of will be well rewarded. You'll earn a share of the increase in the size of the global economy.

The Weighting of the Globally Diversified Fund

The weighting of the fund ensures each market making up the index is in proportion to the market capitalisation of all companies in that market. For example, the US economy accounts for roughly 55% of the global market capitalisation, so approximately 55% of the fund should be made up of US companies.

Japan is around 8% of global market capitalisation, Japanese companies receive an 8% allocation of the fund. Similarly, UK companies receive a 5% allocation of the global fund as this is commensurate of the relative size UK market.

Being globally diversified means that should the Nikkei 225 crash as hard as it did in the early 90s and not recover for 30+ years, this will only account for about 8% of your portfolio. The other 92% of the funds underlying assets will drive the returns for your portfolio.

It's unlikely that the global economy will contract for 30+ years, so most of your risk should be diversified away if invested in a globally diversified index fund.

Why You Should Be Seeking Market Returns

One of the best aspects of being invested in a globally diversified fund is that your returns will be average. Being average means that you'll never be able to beat the market, and you'll only ever earn the market return. Although this sounds counter-intuitive, let me explain.

Average in the investing world is pretty good. Average means your investments will perform better than 50% of people in any given year. In reality, your returns will be a lot better than 50% of investors each year once you take into account transaction costs and the expensive fees of active investment managers into account. Consistently outperforming 50% of people over the long term leads to spectacular results.

You're not Warren Buffett or Charlie Munger, and you will not be able to beat the market in the long run consistently. You have absolutely no idea on how to beat the market. If you did, you wouldn't be reading this.

You will also not be able to pick the next Warren Buffett or select actively managed funds which can consistently outperform the market in the long run. Fortunately, settling for average can give you greater returns than 94.43% of active investors in the long term.

Settling for average means that you will never have to worry about if the stock market is up or down at any given moment or if a company goes bust. In fact, you will never have to read financial news or worry about your investments again. It takes no work on your part, and your returns will be higher than 94.43% of active investors over the long term.

There is no need for you to take a chance in trying to compete against professional investors or the large institutional investors. They are specialists in their field, have learned the market over the decades and have millions a year to spend on research to try to beat the market.

Although half of them can and do beat the market in any given year, once you take fees into account, they underperform. Massively. Your fees are what is paying for their inflated bonuses. You end up severely underperforming the market once we take into account the fees.

Settling for average means, you will outperform 99.99% of other market participants in the long term if your investment strategy is to invest passively.

Avoid Investing in Individual Companies

Many people dislike the idea of passive investing when they believe they can identify the next winning company instead. They genuinely believe they can pick the next Apple or Google on IPO day. A $1,000 investment in Apple on its IPO on the 12th December 1980 would now be worth $430,000.

At the same time, a $1,000 investment in each of Enron, Lehman Brothers, or Carillion on their IPO would now be worth a total of $0. These were once some of the largest companies - the Google or Apple of their respective industries.

Predicting 30, 40 or 50 years into the future is almost impossible.

Apple share price. Source: Google Finance

Back to the Apple example, it would have taken until 2006 to notice any sizeable gain in the share price. Most people (if not all) would have given up after the share price did not increase during its first 26 years as a public company. Apple was notorious to not paying dividends to shareholders during this period.

Even if you did hold your shares for the long term, would you have sold out and realised your gains during the peaks in 2007? 2012? 2015? Or even late 2018? Most people can't predict the future with any degree of certainty, which makes it unlikely that you'll ever pick a winning company and hold the investment through the ups and downs for the required period.

People like to think that they would have invested in Apple back in December 1980. Almost no one would have bought Apple shares on IPO and kept them for 26 years, despite the fact the shares did not increase in value over this period.

It's easy looking back now to think that Apple is a great company, and you would certainly have invested in them on IPO if given the opportunity. Most people didn't, and most investors didn't stay during Apples most difficult periods.

Hindsight is 20/20 and being able to pick the next winning company consistently over the long run is almost impossible. Holding your investment and never selling out is also very difficult over the long term.

If you can predict the future, then there would be no need for you to diversify. You would have one stock in your portfolio, the stock that will have the greatest return over time, outperforming its peers.

By now, you should have realised that betting on single companies is almost like gambling unless you're trading on inside information - which is illegal. You have no idea what the long term outcome will be. You'll be wrong a lot more often than you will be right.

Summary

If you believe the stock market will be higher in the future than it is today, then you should be an index investor. That is, you believe that the market capitalisation of all companies in the stock market will be larger in the future than it is today.

If the stock market as a whole rises in future, companies will be generating more profits in future than they are today. The value of the indices you're invested in and ultimately the value of your portfolio will be higher in future than it is today.

Investing in a globally diversified fund is the king of passive investing strategies. You will be well-diversified, which reduces your risk. You never have to worry about your investments again as it can be easily automated.

It epitomises capitalism as you own a share of all notable companies on the planet. It will also give you returns that exceed 99.9% of other market participants. For non-professional investors, this should be your primary investment strategy.

If there's one book you'll read to learn more about all this, make it The Little Book of Common Sense Investing by Jack Bogle. The late founder of Vanguard.

This is part two of a two part series on passive investing. Part one is "An Introduction to Passive Investing" (see article).


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