International Diversification

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We all like to invest in what we know, so it’s not surprising that investors tend to overweight their home country’s stocks at the expense of international diversification.  This “home bias” seems innocuous, but academic research shows it’s a significant problem for investors.  Concentration in any one country’s equity does not add to expected returns, but does increase volatility and the potential for an isolated incident to have an outsized impact on a portfolio.

But what if that one country is the United States? Prominent pundits have suggested that an investment in US stocks–particularly the largest US companies–is an investment in the world, since most of the largest US companies are multinational and source income globally.  The recent performance of US stocks has been very good over the last 10 years or so, which makes a little home bias seem attractive these days.  That’s not to say non-US stocks have been terrible. They just haven’t put up quite the fantastic numbers the US ones have.  Here are a few things to keep in mind:

  • The relative outperformance of US stocks was influenced by a number of factors that are unlikely to repeat, including the tremendous amount of US stimulus and deficit spending, the meteoric rise of the FAANG stocks, and the stark unpopularity of non-US stocks, particularly in Europe.
  • The performance that happened has already happened, which sounds trite but is true.  Since 2012, US price-to-earnings ratios have jumped from around 11 to almost 22.  Ex-US p/e ratios have risen from around 10 to about 15 today.  Unless economic outcomes greatly diverge between the US and the rest of the world, the US p/e ratios would have to continue to climb higher in the 20s and beyond for the US to continue to outperform at such a powerful clip.  We believe this is unlikely to happen, as typical global stock p/e’s tend to hover in the low to mid-teens, and reversion to the mean is a powerful force.
  • The very factors that influenced US stock performance over the last 10 years could cause problems in the future.  The budget deficits and rising US debt that fueled this spectacular performance of US stocks likely can’t continue to grow at the same rate going forward.  The dollar itself could come under pressure, in which case investors would want to have as many non-dollar-denominated holdings as possible.  The more nuanced approach of, say, the European Central Bank could prove to be a more sustainable effort for the long term.
  • Concentration in any country–even the US–is risky.  There are black swans that by definition can’t be predicted, either in frequency or severity.  What if an EMP attack disrupted power for a prolonged period in a big part of the country?  What if the New Madrid fault experiences the big earthquake that’s been predicted? What if a dirty bomb makes New York City uninhabitable?  Any of these occurrences would have global impact, but I’m almost certain we’d want as much non-US exposure as possible if a major unexpected event affects the United States only.

Recency bias, just like home bias, is a frequent investing mistake.  Even a decade of recent performance is not a sufficient reason to throw away a century of research.  Benjamin Graham famously said markets are a voting machine in the short-term and a weighing machine in the long term.  US stocks are very popular right now, but that has little impact on what the next 10 years might bring.

US stocks make up around 60% of the world’s public markets, and that’s about the percentage of US stocks you’ll see in your Telarray equity allocation if you select our flagship model portfolios.  That other 40% is invested in Europe, Asia, and other developed and emerging markets around the world.  Even if US stocks continue to outperform forever (unlikely), that international diversification still would have functioned as insurance against the unknown. 

We have portfolios available with less international exposure, but we feel strongly that our investors should remain diversified with global equity exposure.  As the saying goes, diversification is the only free lunch in investing.


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