By investing in stocks or stock mutual funds you are investing in businesses. Should you invest only in the businesses of your home country, or is it wise also to invest in businesses in other countries?
There’s some theoretical justification for investing in all public companies in the world in proportion to their market weight. You actually can approximate this approach in a single mutual fund or ETF, for example the Vanguard Total World Stock Index, available as both mutual fund shares (ticker VTWSX) and ETF shares (ticker VT). Below is a chart showing the region allocation for this fund as of 7/31/2010:
As seen in the chart, North America, which consists of the US and Canada, makes up less than 45% of the world stock market; the US is about 41%. So, if we were were to follow a pure global market-weight allocation strategy, US stocks currently would make up only about 41% of the stock portion of our portfolio.
Most investors don’t invest this way. Instead, most investors invest primarily in the stocks of their home country, whether it’s the US or any other country. Economists refer to this as home bias. It’s useful for us to be aware that home bias is common and is not unique to US investors, but is home bias a rational approach to investing?
Larry Swedroe, money manager and author of many investing books, suggests that a major factor in home bias is that investors confuse the familiar with the safe; i.e., investors feel more comfortable investing in their home country because they are familiar with it. Swedroe suggests that confusing the familiar with the safe is a typical investing mistake. Familiarity is not a rational reason for US investors to invest only in US stocks.
So, what rational arguments can be made for home bias, specifically for US investors? Here are the arguments I’m aware of:
- Investing outside the US isn’t necessary for good long-term returns.
- Investing in international (non-US) stocks is riskier.
- The correlation between US and non-US stocks is much higher than it used to be, thus reducing the benefit of international investing.
- Investing in international stocks is more expensive.
- There is currency risk in international investing.
The counter-arguments are:
- There have been many intermediate-term periods where international investing has provided superior returns, and investing in a globally diversified portfolio is consistent with efficient markets.
- Although international stocks may be more volatile, when combined in a portfolio with US stocks, the overall portfolio volatility has been lower than a US-only portfolio over many intermediate-term periods.
- Correlations change over time. In the past there have been periods of relatively high correlation between US and non-US stocks, followed by periods of lower correlation. The correlation between US and international stocks is not perfect, and may be lower in the future.
- While the cost of investing in international stocks is higher, the costs are much lower in today’s world of low-cost index funds, so non-US stocks can be held in at a low enough cost to make the diversification benefits worthwhile.
- A global portfolio diversifies currency risk, and provides the US investor some protection against a declining dollar.
John Bogle, founder of Vanguard and author of many books, articles and speeches on investing, has stated the following in several of his books and speeches: The US financial markets are the best and safest in the world, so it’s unnecessary to invest abroad.1 A related point that he and others make is that multinational US companies derive much of their revenues and profits from outside the US, thus providing some international diversification without investing directly in non-US stocks.
The US probably is the most financially secure country in the world (despite what you may read in the news), but you may be surprised to know that it has not provided the best stock market returns over the last 110 years. For the period 1900-2009, US stock returns ranked fourth, trailing Australia, South Africa and Sweden.2 Still, the US has always recovered from its bad stock market periods, unlike some other countries that have experienced total market failures which wiped out stock investors.
Although the US clearly has been one of the winners over the last century, we don’t know that it will be in the top tier in the next 100 years, or even the next 30. Probably one of the deciding factors for me in maintaining significant international exposure in the stock portion of my portfolio is the possibility that the US could be one of the underperforming stock markets in the next 20-30 years. I don’t necessarily believe that will be the case, but I’m not comfortable placing a huge bet that it won’t be, and investing only in US stocks would be placing such a bet.
Even with their international operations, US multinational corporations don’t respond to the same economic and political factors as companies based in other countries, so many believe that owning non-US stocks does provide diversification beyond US multinational corporations.
Let’s look at the actual results for the last 10 years. For the 10 year period ending 7/31/2010, the total US stock market returned 0.13% compounded annually, while the total world excluding the US returned 4.08%. This would’ve resulted in a cumulative return of close to 50% for non-US stocks vs. almost nothing for US stocks. So, over the last 10 years, global investing definitely would’ve helped cushion a US investor’s portfolio from one of the worst 10 year periods for US stocks.
Regarding risk and correlation, there is evidence to support both the pro and con arguments in points 2 and 3 in the bulleted lists above. My take on this is that the increasingly globalized economy is likely to result in higher correlations between stocks in different countries, so I accept that it’s likely that the diversification benefit of global investing may well be lower than it has been in the past. However, this still doesn’t convince me that I should place all my bets on the US stock market. There is some diversification benefit in owning international stocks, especially if you include emerging markets and perhaps small-cap international stocks in your portfolio. Rick Ferri, author of All About Asset Allocation, argues that you get even better diversification by splitting international developed markets into Europe and Pacific components, which can easily be done with the Vanguard Europe and Pacific mutual funds or ETFs.
Regarding costs, I believe the costs of international index funds such as those offered by Vanguard are low enough to justify the diversification benefits.
Regarding currency risk, it’s true that if the currency of a country declines relative to your home country’s currency, the value of that country’s stocks will decline in your home country’s currency (all other factors being equal). Since you do your transactions in your home country’s currency, the value of your international investments will fluctuate with exchange rates. However, the counter-argument also is true; i.e., international investing diversifies your currency risk--as a US investor, it provides some protection against the risk of a declining dollar. Also, some contend that currency fluctuations tend to balance out in the long run, so they won’t have much long-term impact on a globally diversified portfolio.
Larry Swedroe agrees that the currency argument is a reason to slightly over weight your home country, and so suggests a starting point of 50% US instead of the global weighting of 41%. Although some agree with him, 50% is a higher international allocation than most recommend.
Vanguard did a study that concluded that holding 20% of your stock portfolio in international stocks is likely to get you most of the diversification benefit, and that holding more than 40% does not increase diversification enough to justify it. As with all studies, this is based on looking at performance over certain time periods; other periods could be chosen to justify other conclusions. Nevertheless, the 20%-40% range is consistent with advice given by many investing authors that agree that global diversification makes sense.
Even John Bogle, founder of Vanguard, who has been a staunch advocate of US-only investing for decades, now concedes that a 20% allocation to international stocks may be prudent to hedge against future underperformance of the US stock market.
There is no certainty in the future, so no one knows what international allocation will turn out to be optimum over the next 20, 30 or 50 years. Consider the arguments above, and if you are sufficiently motivated, read more about allocating part of your portfolio to international stocks in the books on my recommended reading list, on the Vanguard web site, or on the other web sites linked to from this blog. Few will fault you with an international allocation of 20% of the stock portion of your portfolio, and many would support an allocation as high as 30%. As you go higher than this, the support will diminish, but you will find some highly respected advisors that support allocations as high as 50%.
1. See for example John Bogle’s speech Globalization of Mutual Funds: Perspective, Prospects, and Trust; specifically the second paragraph of the section entitled Opportunities and Risks Abroad. Interestingly, in the following paragraph, he goes on to state that investors in other nations should invest outside their home country, and specifically in the US.
2. For summaries of the financial market returns of 19 countries from 1900-2009, see the Credit Suisse Global Investment Returns Yearbook 2010.