The best academic studies have repeatedly observed that investors have a home bias. They tend to allocate an amount of capital in their home country far greater than forecasted by the most developed financial models. Investors are often willing to pass on higher gains and lower risks to invest in their home countries. This is a world-wide empirical observation, which is not limited to the US. French investors hold 92% of their funds in French companies despite the fact that the market value of all French common stock is only about 3% of the world total (Malkiel and Mei, 1998). Similarly, German investors overwhelmingly concentrate on Germany, Japanese investors in Japan, Brazilians in Brazil, and so forth. Investors tend to wildly overestimate domestic investment returns compared to foreign ones, and this cannot be explained by taxation, transactional costs, exchange rates, or other institutional constraints (French and Poterba, 1991; Tesar and Werner, 1994). Investing abroad, however, was supposed to be the norm rather than the exception (Grubel, 1968; Levy and Sarnat, 1970; Solnik, 1974). As evidence of this, investors’ portfolios have, on average, lower financial returns and higher risks than a portfolio where stocks are simply allocated according to the respective total capitalization of each country (Tesar and Werner, 1995; Bohn and Tesar, 1996), which can be proxied by a simple ETF (the MSCI ACWI ETF).
Graph 1. Optimum Stock Portfolio of US and Developed Country Stocks
Professors Malkiel (Princeton) and Mei's (New York University) book, Global Bargain Hunting, suggests that the optimum portfolio (for a risk-averse investor) of the U.S. and other developed countries ("foreign") stock is 30/70. Compared to a 100% US ("domestic") portfolio, purchases of other developed countries’ stocks adding up to 30% of the total investment portfolio increases the annual returns of the investments and lower the risks, as the Graph 1 shows. Therefore, 30/70 should be a no-brainer when compared to a 100% domestic portfolio. 100% domestic is not an optimal portfolio for any set of preferences. More than 30% exposure to other developed countries’ stocks continue to increase the returns but also increases the risk of the investment. Hence, a 100% foreign portfolio would be optimal for a risk-taker investor as it would lead to the highest average annual return in the long run.
Why does diversifying across countries lead to lower risks and higher returns? If one market goes into a tailspin, the resulting losses will be counterbalanced by stability or even positive developments in other markets. For example, a portfolio consisting of one country's stocks tends to go down in periods of national economic crisis. A portfolio of multiple countries' stocks, on the other hand, would have much less variation since not all countries are in crisis together and even if they are, the intensity of the crisis varies in each state. In other words, the correlation in stock investment returns across countries is low (Adler and Dumas, 1983; Siegel, 1994). As multiple Nobel Laureates have demonstrated, diversification is key when trying to reduce market risks, such as economic recessions, natural disasters, bad corporate management, and investors' panic. Very few topics in academia are so unanimous as the fact that diversification across countries is highly beneficial for ones' investment portfolio.
Does it mean you will never lose money if you buy foreign market assets? Not necessarily. What it does mean is that broad diversification protects you against the ups and downs of markets that can lead to negative results, i.e. risk.
Did you know?
By also investing in emerging markets you can further increase your returns and decrease your risks simultaneously. According to Nobel Laureate, Robert Lucas, capital should flow from developed countries to poor countries
due to the relative scarcity of capital and thus higher financial returns in developing countries. However, this does not happen. US market capitalization alone accounts for about half of the world’s capitalization. The next five largest stock markets are Japan (7.9%), UK (6.6%), France (3.4%), Switzerland (3.2%), and Germany (3.0%). Meanwhile the Chinese equity market, for example, is about the same size as Hong Kong’s. All other emerging countries have capitalizations smaller than Singapore’s (Bank of America Merry Lynch, 2015). Similarly, developed countries also account for the vast majority of the bond market (Tesar and Werner, 1995). This phenomenon is called the Lucas Paradox and it opens the possibility for further gains by investing in emerging markets.
Graph 2. The world according to free-float equity market capitalization ($bn)
What is the perfect investment portfolio? "It has to be a wildly diversified portfolio. I think that people are too afraid of investing abroad, generally [...]" - Robert Shiller, The 2013 Nobel Laureate
"I can tell you what a simple defensible [investment] strategy would be: S&P 500, have funds outside of the core of the S&P 500, have a European share, and so forth." - Paul Samuelson, Father of Modern Economics, The 1970 Nobel Winner
“You should not ignore the global picture, particularly today because actually [international stocks] are cheaper […] In a low-interest environment they are very very reasonable! So, don’t ignore [the global picture]. I know it is like pulling teeth to get people internationally but, you know, if you can get there, 50%, even, is not unreasonable.” – Jeremy Siegel, Professor of Finance at Wharton School of the University of Pennsylvania
We believe that the home bias and the Lucas Paradox phenomena happen partially because investors tend to have more information about national regulations and procedures, greater familiarity with their native language and customs, and more knowledge about local investment opportunities (i.e. bounded-rationality). Here at Moraya Consulting, we try to diminish these natural barriers by providing the most advanced knowledge in the field and helping to open bank and brokerage accounts abroad so that clients can make the best possible decisions given their individual risk-reward preferences. Moreover, we offer protected returns for long term investors on major stock indexes, such as the MSCI EAFE Index (which follows 21 developed countries' stock markets). See all our products!
- Adler, M., and B. Dumas (1983), “International portfolio choice and corporation finance: A synthesis”, Journal of Finance 38:925-984.
- Bohn, Henning and Linda L. Tesar. (1996). U.S. Equity Investment in Foreign Markets: Portfolio Rebalancing or Return Chasing? American Economic Review. 86:2, pp. 77-81.
- French, Kenneth and James Poterba (1991), “Investor diversification and international equity markets”, American Economic Review 81:222-226.
- Grubel, H.G. (1968). "Internationaly Diversified Portfolios." The American Economic Review. 58,129-1314.
- Levy, H., and M.Sarnat (1970) "International Diversification of Investment Portfolios." The American Economic Review 50, 68-675.
- Lucas, Robert (1990). "Why doesn't Capital Flow from Rich to Poor Countries?". American Economic Review. 80 (2): 92–96.
- Malkiel, Burton Gordon, and J.P. Mei (1998). Global Bargain Hunting: The Investor's Guide to Profits in Emerging Markets. New York: Simon & Schuster.
- Markowitz, Harry (1952). "Portfolio Selection". The Journal of Finance. 7 (1): 77–91.
- Solnik, BiT., (1974). "Why Not Diversify Internationaly Rather than Domesticaly?." Financial Analysts Journal 30, 91-135.
- Tesar, Linda and Ingrid Werner (1994), “International equity transactions and U.S. portfolio choice”, in: Jeffrey A. Frankel, ed., The Internationalization of Equity Markets (University of Chicago Press, Chicago), pp. 185-216.
- Tesar, Linda and Ingrid M. Werner (1995). "Home bias and high turnover." Journal of International Money and Finance,
Volume 14, Issue 4, Pages 467-492.