Don’t Fall Victim To Home Country Bias
Summary The US only makes up 22% of the world economy. Emerging markets in Africa and the Pacific are showing the strongest growth. International stocks are trading at lower multiples than US stocks. We’ve written a several articles in the past about what investments and assets classes shouldn’t be in your portfolio such as commodities , currency funds , and bank loan funds . We also wrote a few articles about asset classes that should be in your portfolio such as international bonds . But, we’ve never discussed how to assemble a comprehensive, well diversified portfolio. It’s important to note we are talking about an investment portfolio so we will not be considering cash which would be part of someone’s savings portfolio. In this ongoing series of articles we’ll be discussing each of the asset classes we use to assemble client portfolios. Over the next few weeks we’ll be discussing each asset class in depth and talking about what risk and reward attributes they bring to a portfolio. For this series of articles we’ve divided the asset classes into three conceptual categories: low risk, medium risk, and high risk. The links to previous articles are below. Low Risk Treasury Inflation Protected Securities ( OTC:TIPS ): Why TIPS Deserve a Spot in Your Portfolio Domestic Government Bonds: Government Bonds Greatest Strength is Downside Protection Medium Risk Currency Hedged Foreign Bonds: International Bonds Belong in Every Investors Portfolio Corporate Bonds Municipal Bonds: Comprehensive Guide to the Municipal Bond Market High Risk Real Estate: REITs Belong In Your Diversified Portfolio Domestic and International Stocks: Don’t Fall Victim to Home Country Bias Summary How to Assemble a Comprehensive Investment Portfolio For investors looking for growth, stocks usually make up the bulk of their accounts. The reasons for investing in stocks are well known; they provide the highest potential returns of all the major asset classes and thus are the growth engine of your portfolio. So rather than rehash the well known case for owning stocks over the long run ( hat tip to Jeremy Siegel ) What I want to focus on is how to properly allocate the stock section of your portfolio to domestic, international, and emerging market stocks. When reviewing client portfolios one of the biggest issues I come across is home country bias. Investors typically overweight their home country and severely underweight global equities. Before we get into why you want to own international and emerging market stocks let’s first examine the one case where home country bias might be the best course of action. Also, since I’m from the US and most readers are from the US I’ll be writing this article from the perspective that the US is our home country. However, everything here still applies no matter what country you are from. When Domestic Bias Can Be a Good Thing Probably the number one argument for overweighting your home countries stocks is if you are a retiree or anyone else on a fixed income that is depending on the dividend income generated from your stocks for living expenses. The reason why you may want to have a portfolio of all or predominately all domestic stocks has to do with currency fluctuations. If all of your living expenses are denominated in dollars then you may want all of your dividend income denominated in dollars as well. While currencies as a whole are a zero sum game and over the long-term currency fluctuations tend to cancel each other out they can be quite volatile in the short term. If your income is close to your expenses, you may not be able to weather a 10% drop in the value of a currency you are receiving dividends in. After all, you can’t very well call the electric company and tell them you’ll pay this month’s bill later once the Norwegian Krone regains its value! This doesn’t mean a retiree should own no foreign stocks. If your expenses are below your income or if you have a decent cushion of cash and can weather some fluctuations, then owning foreign stocks is a great idea. You can also concentrate on companies whose dividend payments are denominated in “safe haven” currencies such as the British Pound or Swiss Franc (this is what we do for our dividend portfolio) instead of more volatile currencies like say the Argentinean Peso. Reasons to Avoid Domestic Bias The primary reason to own international stocks is diversification. United States stocks make up roughly half (depending on what index you look at) of the global stock market. However, because the US has some of the best-developed capital markets and a large amount of publicly traded companies that doesn’t tell the whole story. The United States only makes up around 22% of world GDP according to data from 2014 from the International Monetary Fund. Investing in either foreign companies or US companies that have significant foreign operations gives investors much needed exposure to the 78% or so of the world that is not the United States. While global conditions are always changing, right now international markets have two attractive factors. First, many international markets particularly emerging markets have economies that are growing faster than developed countries. The graphic below based on data from the World Factbook puts worldwide growth rates in perspective. (click to enlarge) We can see that Africa and Asia have many fast growing economies while Western Europe is quite stagnant. Exposure to these high growth markets should be an important component in investors’ stock allocations. Second, and probably most important is that international markets right now can give investors stock exposure at lower multiples then the US market. The table below shows the TTM P/E for the total US stock market ETF offered by Vanguard compared with various Vanguard international market stock ETFs. Fund Index Current Valuation (TTM P/E) Vanguard Total Stock Market ETF (NYSEARCA: VTI ) CRSP US Total Market Index 20.2 Vanguard Total International Stock ETF (NASDAQ: VXUS ) FTSE Global All Cap ex US Index 16.4 Vanguard FTSE Developed Markets ETF (NYSEARCA: VEA ) FTSE Developed ex North America Index 14.3 Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) FTSE Emerging Markets 15.2 Vanguard FTSE Europe ETF (NYSEARCA: VGK ) FTSE Developed Europe All Cap Index 18.7 Vanguard FTSE Pacific ETF (NYSEARCA: VPL ) FTSE Developed APAC All Cap Index 13.9 Many international markets are trading at levels significantly cheaper than the US market. With international stocks, particularly emerging market stocks, having underperformed US stocks in the current bull market it might be hard for investors to rotate out of the winning hand of US stocks. If you’re a macroeconomic expert then by all means concentrate your portfolio in the best geographic areas. However, for most investors they would be best served with a diversified portfolio spread among the entire world. You will have exposure to better performing economies like the US but at above average multiples, underperforming economies such as Western Europe at slightly below average multiples, and faster growing economies albeit with currency concerns at very low multiples. A global stock portfolio insures that no matter which area of the globe is poised to outperform you’ll have some exposure to it.