Ever since the Great Financial Crisis of 2007-2008, when the correlation of all risky assets rose toward 1, investors have been hearing that because of globalization, the world has become flat and the benefits of diversification are gone.
The explanation is generally that the world market has become more integrated and financial markets more globalized. This has led some investors to draw the wrong conclusions about the benefits of international diversification.
With that in mind, we’ll take a deep dive into the issue of how much an allocation to international stocks you should have.
Recent Research From Vanguard
We’ll begin with a look at the February 2019 paper by Vanguard’s research team, “Global Equity Investing: The Benefits of Diversification and Sizing Your Allocation.” The authors, Brian Scott, Kimberly Stockton and Scott Donaldson, began my noting that, as of September 2018, U.S. stocks accounted for 55.1% of the global equity markets—almost twice the low of 29% it reached in the 1980s. Thus, regardless of residence, investors who focus solely, or mostly, on domestic stocks exclude a large portion of the global equity market.
Scott, Stockton and Donaldson note: “The rationale for diversification is clear—domestic equities tend to be more exposed to the narrower economic and market forces of their home market while stocks outside an investor’s home market tend to offer exposure to a wider array of economic and market forces.” Despite the benefits, in a 2017 study, Vanguard found that in each case they examined, investors exhibited a strong home country bias.
When they examined returns over the period beginning in 1970, Scott, Stockton and Donaldson found that “While the United States had the lowest volatility of any individual country examined, its volatility was slightly higher than that of the global market index.”
When they performed a forward-looking 10-year minimum variance analysis, they found that, in each market, the marginal benefit to international diversification declines as allocations to international equity increase, with portfolio volatility beginning to rise with allocations of greater than 40-50% to international equities.
The authors also examined the issue of currency risk. They first note: “Long term, currency has no intrinsic return—there is no yield, no coupon, no earnings growth. Therefore, long term, currency exposure affects only return volatility.”
In terms of volatility, they found that, in all regions, currency risk had very little impact on long-term performance, whether or not it was hedged. Sometimes hedging reduced volatility; in others, it led to an increase.
Scott, Stockton and Donaldson concluded that a good starting point for investors is the global market-capitalization weight. This raises the question of why investors all over the globe exhibit a strong home country bias. The field of behavioral finance provides some likely answers. The first is the tendency to confuse the familiar with the safe.