Old World Map

International Diversification vs. Home Bias

Old World Map

In a recent article on the concept of advisor’s alpha1, Vanguard emphasized the importance of advisors putting their clients into portfolios that they are unlikely to trade under varying market conditions. One of the important factors affecting client’s tendencies to trade is the degree to which the portfolio tracks the market, as measured by widely followed indexes such as the S&P 500 or the Wilshire 5,000. One of the very worst feelings possible for investors is that others are making more money than they are, even when they are still making money. Indeed, this is far more difficult to tolerate than all of us being in the same sinking boat. This is why investors and their advisors should take a cautious approach to allocating their holdings outside of the United States. In two of the last three calendar years, the U.S. markets have substantially outperformed both international developed and emerging markets, so having a globally diversified portfolio has been costly rather than helpful. However, investors who are tempted to forswear their foreign holdings could end up making a costly mistake, as so often happens with reflex reactions to recent performance. To review how different markets perform over the last 20 years, you can see this chart.

Another recent whitepaper2 from Vanguard Research addresses the question of balancing the benefits of international diversification against the behavioral tendency of home bias. The pie chart below shows the current breakdown of the global markets into three main categories.

This chart immediately tells us that a reasonable upper bound on international exposure for a U.S. investor is 50%. Going beyond 50% may be entering the realm of speculation, or making a bet that international will outperform domestic. Please note that over the last 45 years, the U.S. share of the global market has varied between 30% and 70%, so the 50% is by no means a constant guideline.

From a Modern Portfolio Theory prospective, the purpose of international diversification can be stated quite simply as either increasing the global diversification of the small and value dimensions of returns, increasing expected return per unit of risk taken or decreasing the required risk to achieve a desired expected return, which is made possible by the imperfect correlation between the domestic and foreign markets, especially after currency exchange rates are factored in. The chart below reminds us of the benefits of small and value tilts of international and emerging market equities by comparing the S&P 500 to Globally Diversified Index Portfolio 100.

The author of the Vanguard article (Christopher B. Philips) asks just how much of an exposure is needed to accomplish these objectives, and based on extensive testing of historical returns data, he arrives at an answer of between 30% and 40%, with 30% achieving almost all of the benefit derived from a 40% allocation while imparting much less of a home bias problem.  A reasonable starting point would be 20%. According to Morningstar, U.S. investors had a 27% foreign allocation as of 12/31/2013. Philips considers but rejects the idea that international diversification can be accomplished by holding multinational companies such as McDonalds or Amazon.com.

Philips also considers the argument that since correlations and relative volatilities have increased in recent years, the expected portfolio benefit of international diversification is minimal. However, as Philips notes, the assumed continuation of current conditions is the equivalent of assuming a worst-case-scenario, which is usually not a good basis for an investment decision. Furthermore, even if correlations remain high, there will still be periods where foreign outperforms domestic, and investors would regret missing out.  Lastly, Philips considers the question of whether foreign equity holders should hedge their currency risk. As we would expect, the answer is “no” for two reasons. First, hedging increases the correlation between foreign and domestic returns, thereby reducing the diversification. Second, hedging carries a cost, and in this case, it is a completely unnecessary cost. Needless to say, Philips emphasizes the importance of avoiding single country risk when adding foreign exposure to a portfolio. An easy way to accomplish this is through index funds.

If you would like to learn more about IFA’s approach to international diversification using index funds, please call us at 888-643-3133.

1Kinniry, Francis M., Jr., Colleen M. Jaconetti, Michael A. DiJoseph, and Yan Zilbering, 2014. Putting a Value on Your Value: Quantifying Vanguard Advisor’s Alpha”.  Valley Forge, Pa.: The Vanguard Group.

2Philips, Christopher B. 2014. “Global Equities: Balancing Home Bias and Diversification”.  Valley Forge, Pa.: The Vanguard Group.