The concept of diversification is one of the hallmarks of modern investment theory. Diversification offers many benefits, most notably the ability to achieve better returns with lower volatility (something every investor wants), and we have said many times that asset allocation diversification, typically between stocks and bonds, is one of the most important decisions that an investor can make. But what of international diversification? Many fear investing in international markets because they perceive that international markets are riskier than the US, a perception that is not entirely without merit. Yet, the diversification benefits of investing globally, rather than solely in the United States, are significant and once again can lead an investor with more predictable, and higher returns.
The US stock market represents about half of the global market. This is a significant statement since the US is, after all, just one of 195 countries in the world. Yes, many of the largest, best known, most dynamic, and most innovative companies are located right here in the United States. In fact, some well-known companies are as large as some country's entire stock exchanges: Proctor & Gamble is as valuable as the entire Russian stock market, Google as valuable as all the stocks in Brazil, and IBM as valuable as all the stocks in Mexico. With so many amazing companies to choose from it is tempting to simply invest at home.
But an investor who focuses solely on the United States dismisses half of the opportunities in the world. Consider for a moment the missed opportunity of investing only in GM and Ford in the 70’s, 80’s, and rather than the rising Japanese Toyota, Nissan, and Honda. Or consider the importance of global companies like Switzerland’s Nestle and Korea’s Samsung. More importantly, international investing opens an investor to opportunities that are exposed to a very different set of economic factors, governmental actions, and market dynamics. This is what diversification is all about.
So how much international exposure should an investor have? We want the benefit of global diversification, but international stocks tend to be more volatile. Also, during global crashes, the ‘diversification’ benefit can disappear as stocks move together. How can we obtain the benefits of global diversification without introducing even more volatility to the portfolio? According to studies by both Vanguard and Deutsche Bank, adding just a small amount of international stock to a US focused portfolio will reduce the volatility of that portfolio. As we increase international exposure, volatility will decline until international exposure reaches about 30%, far less than the 50% exposure that a straight market weight allocation would imply. Once we go beyond a 30% allocation, the benefits of diversification are reduced, and volatility begins to rise once again.
We strongly believe in global investing. In fact, once the asset class decision has been made, we believe that the allocation to US versus international exposure is the next most important decision. A US only stock investor simply misses the diversification benefits of the international market. If you are interested in learning more about our investment approach or would like us to review your portfolio for ways to improve your approach please give us a call.
*Note: Some argue that holding US companies with a global presence already exposes the investor to the global markets. However, this is only partially true. According to a June 30, 2016, report by Deutsche Bank, US-based companies on average generate 63% of their revenue from the US. By comparison, the typical European company generated only 14% of its revenue in the US.
Philips, Christopher B. "Global equities: Balancing home bias and diversification." Vanguard Research. February 2014. https://www.vanguard.com/pdf/ISGGEB.pdf.
"Investing in international equities: not scary… just practical." Deutsche Asset Management. May 2017. https://etfus.deutscheam.com/US/EN/resources/insights/market-insights/Global_Equities_Whitepaper.pdf.