Market Portfolio

AS INVESTORS DESIGN their portfolio, many will use a 100% U.S. stock portfolio as their starting point and then decide how they’ll deviate. What’s the advantage of this approach? You begin with stocks, which are a portfolio’s engine of growth: They’re the asset class that will give you the best shot at outpacing the twin threats of inflation and taxes over the long haul.

Stocks, of course, also come with the risk of terrible short-term results. This is the reason that investors will add other investments. You can lower a portfolio’s overall volatility by taking some of your U.S. stock market money and shifting it into foreign stocks. But the biggest risk reduction comes from adding conservative investments, notably bonds.

That brings us to an alternative—and perhaps more rational—approach: Instead of starting with a 100% U.S. stock portfolio and deciding what to add, you might begin with the so-called global market portfolio and then figure out what to subtract. What’s the global market portfolio? It’s the portfolio that includes the entire investable universe, with all investments weighted by their market value.

In effect, the global market portfolio reflects what all other investors collectively own, so arguably it’s the ultimate in diversification—and hence the logical starting point as you design a portfolio. The global market portfolio consists of four key sectors, all roughly equal in size: U.S. stocks, U.S. bonds, foreign stocks and foreign bonds. If you focus heavily on just one of these four sectors, you are making a huge market bet on a quarter of the global financial markets—a bet that could backfire.

An example: It took Japanese stocks 34 years to return to their year-end 1989 peak. That has meant disastrous results for Japanese investors who wagered solely on their own country’s stock market and it highlights the dangers of what experts in behavioral finance call “home bias.”

Could we see equally grim results for U.S. stocks? It seems improbable. But the terrible multi-decade performance of the Japanese market would also have seemed wildly improbable in the late 1980s, when the Japanese economy was the envy of the world. To avoid disastrous results like those suffered by Japan, you should probably hold a globally diversified stock portfolio, while also owning at least some bonds.

Next: Diversifying Stocks

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