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, 1998). Similarly, German investors overwhelmingly concentrate on Germany, Brazil investors in Brazil, and so forth. Investing abroad, however, was supposed to be the norm rather than the exception. As evidence of this, US 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, which can be proxied by a simple 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. 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.
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
“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
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). This phenomenon is called the Lucas Paradox and it opens the possibility for further gains by investing in emerging markets. (Click here to read the direct continuation of this article)
The world according to free-float equity market capitalization ($bn)
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. 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.
- 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
- Lucas, Robert (1990). "Why doesn't Capital Flow from Rich to Poor Countries?". American Economic Review. 80 (2): 92–96.
IMPORTANT: THERE IS NO ONE BEST TAX OR INVESTMENT STRATEGY. IT ALL DEPENDS ON YOUR GOALS, RESOURCES, AND CITIZENSHIP.
For example, are you willing to move abroad? If so, where? How long do want to stay in each place? What is your annual income? How much money are you willing to invest? Do you want short term gains or long-term investments? What is (are) the source(s) of your income? How much taxes do you pay annually? Do you want to decrease your tax duties or completely remove them? Do you feel like you want to pay some taxes even if you do not need to? What is your citizenship? Do you have multiple citizenships? Depending on each of these answers the best investment/tax strategy for you will differ. In order to see what option is best for you and to help with the implementation of the strategy feel free to reach out to us. You do not need to be rich to create a global investment portfolio. Most of the bank and brokerage accounts we open do not have minimum initial deposit or maintenance fee. Thus, you can invest as much as you want or even leave the accounts empty until you have enough capital or interest to invest abroad.