Many U.S.-based investors are significantly under-allocated to foreign stocks: while U.S. stocks approximate only 40-45% of global market capitalization, industry data suggests that the average U.S. investor portfolio is dominated by U.S. stocks.
In 2011, a concentration in U.S. stocks has been of benefit — despite the volatile and anemic performance of the U.S. market, foreign markets have fared worse. Unfortunately, this outcome may further blind investors to the substantial risk inherent in concentrating an investment portfolio in any individual country (including the U.S.). Investors may be better served by viewing the recent underperformance of foreign markets as an opportunity to increase their non-U.S. exposure at attractive price levels.
Regardless of an investor’s home country, the rationale for global diversification is clear — stocks domiciled in foreign countries provide exposure to a wider array of economic and market forces. At a high level, the benefit of global diversification can be shown by comparing the volatility (i.e., fluctuations in value) of U.S. stocks to that of all global stocks in aggregate. Based on research conducted by Vanguard, the average historical volatility of the global portfolio is meaningfully lower than that of the U.S.-only portfolio.
This result may seem counterintuitive to many American investors as foreign markets are often perceived as riskier than the U.S. market. While this can be true at the individual country level, broad diversification across many countries actually reduces volatility relative to a U.S.-only portfolio.
Volatility, though, is only one aspect of risk. A more important risk is the downside potential associated with over-concentration. Concentration risk is particularly acute with a single stock, but the same concept applies to individual countries — it is impossible to accurately forecast the future of any one stock or country, so it is prudent to diversify among many. Additionally, country diversification has grown increasingly necessary for achieving industry diversification — for example, as the U.S. has become concentrated in industries such as software, IT services, and biotechnology, ‘old-world’ industries such as electrical equipment, durable household goods and automobiles are dominated by other parts of the world.
Just as familiarity often leads employees to invest exclusively in their company’s stock, natural behavioral biases lead U.S. investors to own primarily U.S. stocks. This comfort is only reinforced by the strong returns U.S. stocks have produced over the very long-term. Despite this track record, however, it is interesting to note that the equity markets of Australia, South Africa and Sweden have each outperformed the U.S. on an inflation-adjusted basis over the 111 year period from 1900 through 2010!
Few investors would conclude from the historical results that their portfolio should be concentrated solely in the stocks of Australia, South Africa or Sweden; likewise, neither should they conclude that only U.S. stocks should be held. This leaves a simple question: what is the optimum level of foreign equity exposure?
Vanguard’s research indicates that historical portfolio volatility for U.S. investors was minimized by allocating 40% of an equity portfolio to foreign stocks. This analysis underlies their recommendation that investors maintain a foreign allocation of at least 20% and as high as 55-60% (in line with global market capitalization). Jason Zweig, personal finance columnist for the Wall Street Journal, reaches a similar conclusion stating, “it is imperative to have a third to half of your stock money outside the U.S., where other markets — and currencies — may do better.”
Given the often higher costs of foreign investing, and the fact that most U.S. investors are likely to be spending mostly U.S. Dollars in retirement, we do believe a “home bias” (i.e., allocating more to U.S. stocks than their world market weighting) is warranted. Balancing the benefits of a home bias against the diversification merit of foreign stocks leads us to recommend a foreign equity allocation approximating 40%. Not only does this global diversification reduce portfolio risk, it also creates rebalancing opportunities as performance varies across regions — just as we are experiencing today.