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Global Diversification: Free Lunch, Anyone?

“It’s better to be vaguely right than precisely wrong.” - John Maynard Keynes, Economist

What percentage of your portfolio is allocated to US stocks?


While the US stock market is easily the world’s largest equity market and represents about half of the global market capitalization, there are thousands of investment opportunities across the globe you might be missing out on.


The average American allocates roughly 80% of their portfolio to companies domiciled in the US, representing a massive overweight known as home bias.1


In fact, home bias haunts investors all around the world, not just in the United States. For example, Australians hold a high percentage of Australian stocks, Canadians hold a high percentage of Canadian stocks, and so on and so forth.


Though you may not know it, a portfolio with concentration toward one country is effectively an active bet that it will outperform the rest of the world.

Source: Vanguard, “The Global Case For Strategic Asset Allocation and An Examination of Home Bias.”


Though US stocks have performed well over the last decade, the United States has never been the single best-performing country for annual stock market returns over the past 20 years.2


To make matters worse for home-biased investors, there is no discernible pattern for the timing of country performance. The chart below ranks developed country’s market returns year-over-year for the past 20 years. As you can see, market returns are random, highlighting the difficulty of executing a strategy predicated on choosing one country over another.

Source: Dimensional Fund Advisors LP


Ideally, one could forecast in advance which countries would outperform, but there is no available evidence suggesting anyone has been able to reliably and consistently identify such countries.


Lacking this foreknowledge, your next-best option is to own all countries as part of a globally-diversified strategy.


Generally, the average long-term returns of US and international equities are similar, but their paths to those returns deviate greatly.


As evidenced by the chart below, US equity performance compared with international equity performance has been highly cyclical. Foreign companies have different characteristics and economic drivers than US companies, producing different levels of returns for varying durations.

Source: Morningstar Direct, Vanguard analysis.


While the US has performed well as of late, it was not long ago it was one of the weakest performing countries. From 2000–2009, US stocks (as measured by the S&P 500 index) were down 9.1% cumulatively – an entire decade that resulted in a negative return.3


The US was one of the best performers in the 90’s, but before that, you have to go back to the 1920s for the US to rank as one of the best-performing countries.


The last reason why it may be prudent to consider adding more global diversification to your portfolio is because of current valuations.


Valuations today point to a higher probability of international stocks outperforming US stocks over the next decade. The graph below shows international stock valuations haven’t been this low relative to the US in 20 years.

Source: ETF Trends


Current valuations don’t tell us much about short-term future returns, but they tend to tell us a lot about longer-term future returns.

As stated, diversification has many benefits to investors. It is often referred to as the only free lunch in investing because a portfolio comprised of globally-diversified stocks should be expected to produce a superior risk-adjusted return than any one country held in isolation, while also decreasing volatility.


Due to the randomness of returns, cyclical nature of performance, and current valuations, there might never be a better time to diversify your portfolio.



Sources:

1. The Buck Stops Here: The global case for strategic asset allocation and an examination of home bias Vanguard – July 2016

2.https://www.theglobonomy.com/rankings/Stock_market_return/

3. https://us.dimensional.com/perspectives/randomness-of-global-equity-returns