Familiarity Breeds Investment
With the breakup of AT&T (“Ma Bell”), shareholders were given shares in each of what were called the Baby Bells. A study done a short time later found that the residents of each region held a disproportionate number of shares of their local regional Bell. Each group of regional investors was confident their regional Baby Bell would outperform the others. How else can you explain each investor having most of their eggs in one baby basket?
Investors tend to view domestic stocks as safer and better investments than their international counterparts. For example, a study by Ken French and James Poterba, “Investor Diversification and International Equity Markets,” found that the expected real return to U.S. equities was 5.5% in the eyes of U.S. investors, but only 3.1% and 4.4% in the eyes of Japanese and British investors, respectively.
Similarly, the expected return on Japanese equities was 6.6% in the eyes of Japanese investors, but only 3.2% and 3.8% in the eyes of U.S. and British investors, respectively. Familiarity breeds overconfidence (or an illusion of safety), and lack of familiarity breeds a perception of high risk.
Many investors avoid adding international investments to their portfolios because they believe international investing is too risky. Is this perception accurate? Debra Glassman and Leigh Riddick, authors of the study “What Causes Home Asset Bias and How Should It Be Measured?” found that portfolio allocations to foreign and domestic securities by U.S. investors are consistent with the belief by investors that the standard deviations of foreign securities are higher by a factor of 1.5 to 3.5 than their historical value.
The evidence demonstrates investors tend to make mistakes due to biases they are likely unaware of. You no longer have that excuse. And there’s another bias that U.S. investors have to deal with—recency.
“Recency” is the tendency to overweight recent events/trends and ignore long-term evidence. This leads investors to buy after periods of strong performance—when valuations are higher and expected returns are lower—and sell after periods of poor performance—when prices are lower and expected returns are higher. This results in the opposite of what a disciplined investor should be doing: rebalancing to maintain their portfolio’s asset allocation.
Recency bias becomes an even greater problem in combination with familiarity bias. The table below examines the returns over the past 10 calendar years from 2009 through 2018.
Looking at these results, it’s easy to understand why U.S. investors might be questioning the benefits of international diversification. However, to address questions about where the benefits can be found, we don’t have to look too far back in time.
The problem is that investors’ memories can be short, often much shorter than is required to be a successful investor. The period we’ll examine is the five years from 2003 through 2007, the period just before the Great Financial Crisis.
As you can see, results from 2003 through 2007 were the reverse of what they were from 2009 through 2018, with international stocks far outperforming U.S. stocks. As Spanish philosopher George Santayana famously warned, “Those who cannot remember the past are condemned to repeat it.” In general, dramatic outperformance (underperformance) is accompanied by rising (falling) valuations, which generally lead to reversion in returns—higher valuations predict lower future returns and vice versa. Given the last 10 years’ returns, it should not be a surprise that U.S. valuations are now much higher than international and emerging market valuations (the best predictor we have of future returns). The table below shows the current forward-looking P/E ratios for three of Vanguard’s ETFs. Data is from Morningstar as of January 31, 2019.
- Vanguard S&P 500 ETF (VOO): 16.1
- Vanguard FTSE Developed Markets ETF (VEA): 12.6
- Vanguard FTSE Emerging Markets ETF (VWO): 11.5
As you can see, valuations are considerably lower for international stocks. While that suggests they have higher expected returns, it’s important to understand the lower valuations don’t mean they’re better investments. The lower valuations reflect the greater risk investors perceive.
We’ll now address the issue of international diversification failing when it was needed most, during the financial crisis.