In our previous two posts, we’ve discussed asset class diversification and investment strategy diversification. In today’s post we’re going to discuss the importance of geographic diversification, which is commonly missing from investor portfolios, especially in the U.S.
Not surprisingly, most investors have a geographic preference for their home country within their investment portfolios. In other words, a disproportionate amount of their 401(k), IRA or taxable investment portfolios are invested in stocks and bonds of companies within their home countries. Rightly or wrongly, we all have a strong tendency towards exhibiting home country bias. This bias can lead to disastrous portfolio outcomes. Think of the Bolshevik Revolution in Russia in 1918. If a Russian investor had been 100% invested in Russia his/her portfolio would have been reduced to zero. That’s right. He/she would have lost everything. While the Russian Revolution may seem like a long time ago and not particularly relevant to our day and age, we’ve witnessed similar situations of individuals’ familiarity bias with the companies that employ them. Think of all the employees of Enron or Lehman Brothers that had actively allocated to their employers’ stock either voluntarily via their 401(k) plans or passively by not exercising company granted stock options. It’s the same principle and the same outcome.
Numerous studies, back-tests and actual ‘real-life’ investment returns have demonstrated the benefit of international diversification. Again, the idea of diversification is to reduce the magnitude of draw-downs in your portfolio while maintaining attractive long-term return potential. Portfolios that suffer large draw-downs obviously aren’t able to compound returns as quickly as those that suffer smaller draw-downs. So the goal is to be invested but to be invested in such a way that you minimize draw-downs and maximize the compounding of returns. By allocating reasonable amounts of investment portfolios to various geographies, an investor is able to improve long-term return upside prospects while lowering downside prospects.
The US comprises just over 50% of global stocks based on market capitalization. However, the average US investor allocates nearly 75% of his/her equity allocation to US stocks, representing a nearly 50% overweight of US stocks based on global index weights. While US stocks have led the way in performance terms relative to the rest of the world during this decade, the last time the US led the world in stock market returns over a decade was the 1910s. So investors exclusively or heavily invested in the US prior to this decade have likely missed out on performance by not having a higher international allocation within their investment portfolios.
How To Do It
The best way for most investors to gain reasonable international exposure is to invest in a global or international index fund. Index fund exposures track actual index exposures, which usually in proportion to actual stock market size. For example, investing in a fund that tracks the MSCI All Country World Index would provide an investor with reasonable exposure to the US and international equity markets most likely based on the weights of the underlying index itself (NOTE: make sure you or your adviser always review prospectuses and any other documentation to ensure there is an understanding of how the fund tracks/replicates the underlying index and that you’re actually getting the country exposures you think you’re getting). With the advent of low fee investment vehicles it’s relatively easy for an investor to gain diversified geographic exposure at a very reasonable cost.
With the world apparently reverting from the massive globalization movement of the past few decades, geographic diversification will likely take on an increasingly important role within investment portfolios. In the figure below, courtesy of Charles Schwab, we see global stock market correlation has been in decline since the last recession, which may reflect the gradual unwinding of the aforementioned globalization movement that began in the late 1990s. As a result, over-weighting the US relative to the rest of the world might not be the best trade over the next decade or two, especially given the US’ excess returns over the past decade.