Avoid Portfolio Patriotism – Invest Globally
In their Spring 2015 ETF Perspectives newsletter for advisors, Vanguard discusses an often overlooked weakness that is prevalent across the portfolios of many U.S. investors; an overallocation to U.S. equities. This phenomenon is known as the home country bias.
“When I put that together with the home-country bias and look at portfolios in the United States, both individual and institutional that tend to be very underweighted [in foreign exposure], I wonder whether that’s not an area that we should be thinking about more carefully.” – Burton Malkiel author of the famous A Random Walk Down Wall Street
Home country bias (portfolio patriotism) is the tendency of investors to overweight investments to companies domiciled in their own
country. This happens because most investors prefer to invest in things they are most familiar with. With familiarity comes comfort. It’s easy, it’s available and it’s something you hear about on the news every day. This bias is not as problematic for U.S. investors as foreign investors simply because the U.S. stock market makes up nearly 50% of the global market cap. Even at that, however, it isn’t uncommon to find investors with 70% or greater of their equity allocation in U.S. stocks.
Heavily allocating to domestic equities poses a couple big problems. One problem is that an overexposure to any asset class can significantly increase the risk of a large drawdown. A second major problem is the missed investment opportunities caused by too narrow a focus on a single category of investments.
First, let’s review the risk a weakly diversified portfolio exposes an investor to. In a standard 60/40 portfolio (60% stocks, 40% bonds), if 75% of your stock allocation is in U.S. equities, a 20% correction in the U.S. stock market means your portfolio would lose 9% of its value. A 60/40 allocation is somewhat conservative, however. With many of the younger investors I work with, I often see (although do not recommend) a more aggressive 90/10 split between equities and bonds. In this case, if 75% of the equity allocation is U.S. equities, a 20% correction in the S&P 500 would result in a 13.5% loss to the portfolio.
How often do 20% corrections happen in the U.S.? While the past few years have been characterized by subdued volatility, it’s important not to fall victim to the belief that the current trend must continue (recency bias). 20% corrections probably happen more often than you think. According to a study of the S&P 500 by QVM Group, from 1983 to 2012, 18% of quarters have a price at least 20% below the 4 quarter trailing high (average 0.73 times per year).
While a 13.5% loss might be acceptable to those with a long-term investment horizon, the risk of such a drawdown can most certainly be mitigated by diversifying internationally. Small improvements to returns can make a big difference.
The second issue with under allocating international equities is the opportunity cost. Personally, I think it’s difficult to overstate the opportunities available in developed and emerging markets abroad. I’ve recently highlighted data that suggests that U.S. stock market returns in coming years may be relatively muted. If value is your target (as is often ours) and this is a view you agree with, your odds of finding suitable investments domestically in coming years will be greatly reduced. With nearly any investment strategy, expanding the investable universe means increasing the number of investment occurrences. More occurrences mean a greater probability of achieving a desirable outcome (law of large numbers).
In the chart below we see that over the last 40+ years there have been several extended periods where foreign markets have outperformed the U.S.. There is little reason to believe this trend will not continue.
We also see that adding non-U.S. stocks to an equity allocation has historically reduced the total volatility of a portfolio.
In closing, it is important that investors learn to be objective in dealing with their portfolios. While domestic markets may provide a certain level of comfort, thinking globally has many benefits. There’s no reason to ignore more than half of the opportunities available to you. As Vanguard correctly points out in their newsletter, the costs of global diversification have never been cheaper. Take advantage of it.
For more insights, sign up for AWA’s Weekend Reading newsletter.