If you’re like most investors, about 20-25% of your equity allocation is invested in international stocks.
And you probably think that’s enough.
I believe it should be more like 40-50%.
DON’T YOU WANT YOUR FAIR SHARE?
It turns out that stocks of companies outside the US make up 55% of the value of the world stock market. So if we’re looking to own our fair share of the global stock market, our portfolios would be 55% international. If we want a representative portfolio, our equity holdings should be 55% international.
When we invest in the S&P 500, we hold a representative share of each stock in the S&P 500. When we invest in the Total US Stock Market Index, we hold a representative share of each stock in the US Stock Market.
So why wouldn’t we do the same thing when we invest in the Global Stock market? Why do most US investors hold 75-80% of their stocks in US companies?!
THERE’S NO PLACE LIKE HOME
The answer is home bias. Home bias is the tendency to invest disproportionately in stocks close to home, and we see this effect in every country around the world.
Japanese, British, German and French investors each hold 80% or more of their equity domestically.
So why do we stay so close to home in our investment portfolio? We do it because we feel more comfortable investing in companies that are more familiar to us. I believe we do it because we fear the unknown. It’s just human nature, and we see it in our non-financial lives as well.
DO YOU LIKE FREE LUNCH?
There’s a saying that “diversification is the only free lunch in investing.” Let’s say there are 2 stocks in different industries, and each one has an expected return of 10%. Whether you own 1 of the stocks or both of the stocks, your expected return is still 10%.
But your risk is lower holding both stocks than just holding one of them. This is the beauty of diversification, and holding that second stock is essentially free. The benefits of diversification, in other words, are essentially free.
Well, it turns out that holding a healthy slice of international stocks works just the same way.
In fact, Vanguard has a great white paper that shows you actually reduce the risk of your overall portfolio as you add international stocks, all the way up to an allocation of 30-40% international stocks. Said differently, a portfolio of 20% international stocks is actually riskier than a portfolio of 30-40% international stocks. Economist Karen Lewis found that holding 39% in international stocks minimizes portfolio volatility.
This may sound surprising to you, since international stocks are slightly more risky than US stocks – but this is the power of diversification!
JUST HOW AMERICAN ARE YOU, ANYWAY?
So far we’ve just been talking about international stocks in your equity portfolio.
But what if we take a step back and consider your entire financial life? I think you’ll find that your financial life is almost completely tied to the US economy, and that this is yet another reason to consider significantly increasing your allocation to international economies by holding more international stocks.
- Do you own real estate in the US?
- Do you work for a company in the US?
- Do you have a pension in the US?
- Do you (or will you) collect social security from the US Government?
If you’re like most of my readers, you answered an unambiguous “yes” to these questions. Now consider the magnitude of these lifetime assets and income. We’re presumably talking about millions of dollars tied directly to the US economy, not to mention the 75-80% of your equity portfolio you probably have in US companies!
When you look at this bigger picture of your financial life, how does that 20-25% international equity allocation look now? I think you’ll agree that it’s starting to look pretty small!
What if the US economy struggles relative to foreign economies in the coming years? Do you feel comfortable being so tied to a single economy?
BUT AREN’T US COMPANIES ALREADY GLOBAL?
I sometimes hear the argument that many US companies are true multi-nationals, so that investing in US stocks is actually investing internationally, so there’s no need to worry about investing directly in international stock markets.
While we certainly live in a much more global economy than we used to, and the correlation between US stock returns and international stock returns has increased, US stocks still tend to “zig” when International stocks “zag” – and vice versa. If anything, it now takes even more of an international allocation to achieve the all the benefits of diversification than it used to!
SO WHY DON’T FINANCIAL ADVISORS RECOMMEND MORE INTERNATIONAL STOCKS?
Financial advisors tend to recommend 20-25% international stocks.
Given the arguments above, why would they keep doing this?
Well, financial advisors are human and have the same home bias that the rest of us do.
Also, it is much easier for a financial advisor to recommend 20-25% international stocks than to recommend 40-45%. Recommending a lot more probably feels like sticking your neck out there, because it isn’t the norm. And recommending a lot more means you need to take extra time educating your clients!
SO WHAT’S THE PERFECT NUMBER?
I can’t give you one, but if you’re sitting at 20-25% international like most people, I would challenge you to consider how home bias might be impacting you, how significantly your broader financial life is tied to the US economy, and the potential “free lunch” diversification benefits of increasing your international allocation.
After you consider all of these factors, maybe you’ll decide to stand pat at 20%.
Or maybe you’ll target an allocation closer to the 55% represented by international stocks.
Either way, I think you’ll agree that there’s a big economy out there outside the US, and that you should at least consider owning a bigger piece of it.
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