PART 10: War of the World Stocks

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Now that you have your overall allocation of stocks to bonds established (and if you don’t, please go back and see Part 9 on asset allocation), the next step is to determine how much of your stocks allocation will be given to international stocks. At first glance, this seems like a simple consideration, and you might be asking, why dedicate an entire section to this? Here’s the thing: whether or not to invest internationally has been a highly debated topic among investors, and it’s worth reviewing some of the arguments both ways. This also offers us an opportunity to examine some of the “traps” that investors can fall into, and learn how to avoid them. Let’s get into it.

Author’s Note. I should say at the outset that as I am investing in the United States, my discussion here will largely be U.S.-centric; this means that when I talk about “international equities,” I am referring to stocks outside the United States. International readers will undoubtedly have a different definition of the word “international,” but the points we will be discussing here are equally applicable elsewhere.

The Argument Against

There are many investors who choose not to include international stocks in their portfolio. The reasons for this can be varied—and we’re going to look at some of them—but it’s worth noting that there are some very well-respected investors in this corner. We’ll be referencing two of them throughout this section: John Bogle, widely considered the father of index investing and founder of Vanguard, and JL Collins, author of the phenomenal book The Simple Path to Wealth. From my experience, the reasons investors choose to forego international equities comes down to two broad rationales: additional risk, and the belief that they are largely unnecessary. JL Collins summarizes this nicely when he notes that he doesn’t recommend international equities for “three reasons: Added risk, added expense and we’ve got it covered [with the global presence of domestic corporations]” (The Simple Path to Wealth 119).

JL Collins doesn’t recommend international equities for “three reasons: Added risk, added expense and we’ve got it covered [with the global presence of domestic corporations].”

The Simple Path to Wealth

First, it’s important to know that international equities bring a possibility for a higher return, but also carry some forms of risk that domestic stocks do not have. Let’s look at some of these:

  • Currency risk. Because international markets trade stocks that are valued in foreign currencies, there is an additional factor to consider when investing internationally: the going rate of currency exchange. As Mel Lindauer et al. note in The Bogleheads’ Guide to Investing, “a foreign stock investment is really two investments—one in stocks and one in currencies” (100). This essentially means that depending on the strength of the U.S. dollar (relative to other currencies), there may be additional momentum (or drag) to investing internationally. And if you’re in the mood to be perplexed, consider this: it doesn’t work the way you might think. John Bogle notes in Common Sense on Mutual Funds that “A strong dollar reduces the returns earned by U.S. investors in foreign markets; a weak dollar increases the returns earned in foreign markets” (254).
  • Different regulations and accounting standards. Foreign markets can also have a wide range of different accounting standards and market regulations; depending on the country, these can vary from secure to entirely anemic. For developed markets, this is not much of a concern. These markets tend to be as well-regulated as what we’re familiar with here in the United States, resulting from having well-established economies and strong government regulatory presence. With emerging markets, however, these standards can be up in the air. Remember, as we learned in Part 7, emerging markets are more turbulent (and risky); some may have pre-industrial economies, some substandard infrastructure, and so on. They can also be in a period of rapid transition (as they grow and hopefully evolve into developed markets). The crucial factor is whether the country’s regulations and accounting standards are adequate, and can keep pace with the increased vulnerabilities a growing market brings. Some do, and some don’t.
  • Risk of political instability. According to Fidelity research, this is the leading cause investors cite when choosing not to invest internationally. When investors choose to invest internationally, they also to a degree expose their portfolios to the political, social, and economic events (either favorable or unfavorable) that may occur in those countries.

In addition to risk considerations, there is also an argument to be made that if you are invested in U.S. stocks, especially large-cap (large companies), you are already invested somewhat internationally, as most of these companies have a global presence. As JL Collins explains, “the 500 largest stocks in the U.S. make up about 80% of [the total market]. The largest of these 500 are all international businesses, many of which generate 50% or more of their sales and profits overseas. Companies like Apple, GE, Microsoft, Exxon/Mobil, Berkshire Hathaway, Caterpillar, Coca-Cola, and Ford to name a few” (The Simple Path to Wealth 120).

I want to be clear: I don’t find fault with any of these points. From my experience, they are all valid, and need to be taken into consideration when you are evaluating international investments for your portfolio. For these reasons (and more), John Bogle concluded in his 2010 book Common Sense on Mutual Funds, “Overseas investments—holdings in the corporations of other nations—are not essential, nor even necessary, to a well-diversified portfolio. For investors who disagree—and there are some valid reasons for global investing—I would recommend limiting international investments to a maximum of 20 percent of a global equity portfolio” (252). And, as I mentioned above, while JL Collins does not strongly oppose international investments, he also does not find the reasons for them sufficiently compelling.

However, I’ve also found that reasons not to invest internationally are not always this sensible and valuable. Two, in particular, reflect certain biases that investors may have that—if left unchecked—can be destructive to an investment plan. These are recency bias and home country bias. Let’s take an in-depth look at each.

Recency Bias

Recency bias, simply put, is a form of cognitive bias that causes us to assign more weight to recent events than those that have occurred farther in the past. Schwab has an informative article on recency bias that amusingly notes: “Would you want to go for a long ocean swim after watching Jaws? Probably not, even though the actual risk of being attacked by a shark is infinitesimally small.” This tendency is hard-wired into us. Throughout the development of our species, being able to evaluate past events—in order to establish patterns that we can then use going forward to make helpful predictions—was a game-changer. And, in most areas of life, relying more heavily on recent events to make decisions makes sense; consider the decisions we make based on recent weather patterns, or our recent state of health. In most cases, this tendency can be enormously helpful.

Recency bias is a form of cognitive bias that causes us to assign more weight to recent events than those that have occurred farther in the past.

However, as we’ve discussed previously, investing is one area where this tendency betrays us. Where investing is concerned, we cannot rely on past performance—even very recent past performance—to indicate what the future holds. For example, recency bias can cause us to sell investments at a loss in a down market (under the assumption that the decline will continue), or buy heavily into a sector that has recently outperformed (buying at a high, and exposing us to greater risk—such as the extreme over-speculation that occurred during the Dot Com Bubble). The truth is, the market is unpredictable, and reacting to short-term volatility or trends rather than taking a long-term view can be damaging to your portfolio. The market often does exactly what you expect it not to.

So how do international equities fit into all of this? Here’s the thing to understand: domestic and international equities outpace each other over different time periods. One will outperform the other, and then the pendulum will swing and the opposite will take hold for a while. To a degree, it’s cyclical—with the cycles being unpredictable. For example, the last decade (2010-2021) just happens to be one in which U.S. stocks have outperformed international. Taking a look at the decade prior to this (2002-2009) will show you one in which the opposite was true. So it is throughout other time periods. Take a look at this chart from Fidelity Research below showing 1972-2019.

Source: Fidelity Research

Fidelity also notes in the accompanying article: “While US stocks have had higher returns than overseas stocks in aggregate for the past several years, the best-performing stock market in 6 of the last 8 years has been located outside the US…Historically, developed market international and US stock performance is cyclical: One typically outperforms the other for several years until the cycle reverses (see chart). Timing these rotations is difficult, though, which is why it’s important to have both US and non-US exposure in an equity portfolio. Investors underexposed to foreign stocks could miss significant gains when overseas markets rally, or suffer losses when US stocks decline.”

So, at times the U.S. market leads, and sometimes international markets. Which will be true going forward? No one knows. Some believe that this period of U.S. outperformance is coming to a close, and the pendulum is about to swing the opposite direction. Vanguard’s Market Perspectives report from March 2022, for example, projects the following annualized returns for the next 10 years (before inflation).

Is Vanguard correct? Will international markets outperform for the next decade? Ask me in 10 years. Again: no one truly knows—not Vanguard, not you, not I (much as I wish I did). No one. And this is the point: rather than try to predict which will outpace the other over our particular investment window, the better option is to not let recency bias color our view, and simply own both. Looking more closely at recent outperformance—and assuming that this outperformance will continue in perpetuity—flies in the face of what history has shown us, and can lead investors away from being properly diversified.

Home Country Bias

Home country bias is the well-established tendency of investors to have a strong preference for investing in their home country. This stems from the fact that most people are more comfortable with things they are familiar with—and this tendency becomes heightened when we are talking about putting one’s money on the line. Investors are naturally more inclined to invest in companies they see and interact with on a daily basis. For example, investors in the U.S. are likely far more comfortable investing in Apple or Amazon than they would be in Taiwan Semiconductor or Alibaba Group. So, just how significant is home country bias? Consider this chart from a 2017 Vanguard study.

Source: Vanguard

Compared to the global market weighting of their respective home country, investors around the world tend to heavily tilt their portfolios domestically. For example, though Australia holds just 2.4% of the global market weighting, Australian investors tend to invest an average of 66.5% of their portfolios there; said another way, Australian investors domestically overweight their portfolios by 27x more than is justified by their country’s market weight. And, as you can see, this tendency isn’t just isolated to Australia: investors in the United States overweight their portfolios by 1.5x, Canadians by 17.4x, the British by 3.7x, Japanese by 7.7x, and so on. Investors prefer the familiar, and by a wide margin.

To an extent, home country bias makes a certain sense: investors should believe in the investments they choose. However, investors should also understand that their perspective is limited by their experience. The danger here is in excluding potentially great companies—and significantly limiting diversification—based solely on the fact that one isn’t familiar with a certain area of the world. For example, the United States accounts for roughly 58% of the global market capitalization. However, many investors simply shrug off that remaining 42%, and choose to invest solely in domestic equities. This means that they lose diversification potential in some truly fantastic international corporations based solely on the fact that they are not aware of them. To help illustrate this, here’s a useful graph from the Visual Capitalist of the top 100 companies in the world. (Hovering over the chart will allow you to zoom in.)

Source: Visual Capitalist

As you can see, the United States does offer a large concentration of fantastic companies, but to say that it captures all of them (or even most of them) is misleading. By choosing to invest only in U.S. stocks, investors miss out on companies like Samsung, Nestle, Sony, and Toyota, not to mention the next great companies of tomorrow that happen to be overseas.

John Bogle, the father of index investing, has famously said, “Don’t look for the needle in the haystack. Just buy the haystack!” This is, after all, the heart of the philosophy behind index investing. At the company level, we recognize the sheer difficulty of picking individual stocks that will outperform, so we don’t try—we own them all. Taking a slightly larger view, we also don’t try to predict which sector or stock style will do well for our particular timeframe; we choose to diversify, and own them all. Zoom out with me one final time—to the world stage. Why would this philosophy suddenly change at this level? Why would we assume that “the haystack” somehow inexplicably ends at our borders, and pretend that there aren’t companies of worth outside of them? After all, the 42% of the global market that international equities make up is a lot of diversification potential to give up. It seems to me that the truest and most consistent form of “buying the haystack” is to actually buy the haystack—not just 58% of it. 

It seems to me that the truest and most consistent form of “buying the haystack” is to actually buy the haystack—not just 58% of it.

There have been examples throughout history that demonstrate the danger of relying too heavily on one country’s equity market. One of the most well-known occurred in Japan in the late 1980’s. As Mel Lindauer et al. observe in The Bogleheads’ Guide to Investing, “The history of the Japanese stock market may provide the best evidence of how diversification among international stocks can be worthwhile. At the end of 1989, the Japanese stock market’s capitalized value was the largest in the world [43 percent]. The Nikkei 225 Index reached an all-time high of 39,916. Twenty-two years later, the Nikkei was under 8,500. As of this writing, the Nikkei remains far below its 1989 high. Sad is the Japanese investor who failed to invest in international stocks outside Japan. Who can say that the same thing could not happen to U.S. stock investors?” Who indeed?

One additional note—on the idea that investing in large-cap U.S. companies already provides sufficient international exposure, as they operate globally: Domestic companies with international sales are fundamentally different than companies domiciled outside the United States. Meaning that revenue exposure, in my opinion, is not sufficient to ensure adequate international diversification. Ex-U.S. companies gain the benefit (or drawback) of being domiciled in their home countries, have full exposure to all the local/regional economic factors, and draw the majority of their sales predominantly from their region of the world—and in their local currency (which no American company can claim). As I noted above, each of these can either be a boon or a drawback, depending on a myriad of factors. The key point, however, is that choosing to invest outside the U.S. ensures that your portfolio is not anchored largely to one country’s equity market. You own the world in a way a solely domestic portfolio cannot lay claim to.

A Note on Diversification

Since we’ve touched on diversification so frequently throughout this post, let’s pause for a moment and discuss it further. Some of you might have noticed that in choosing to diversify into several asset classes that do not move in concert with one another, this means that some parts of your portfolio will lag behind others at times. This is true. But let’s look for a minute at what true diversification entails. There are two main considerations when it comes to diversification—and both are equally important:

  1. Diversifying within asset classes (such as investing in broad-market funds).
  2. Diversifying across multiple asset classes (with low, or no, correlation to each other).

Let’s tackle the first consideration…first. As we discussed in Part 7, the funds we have selected for our asset classes are already broad-market. For our stock funds, this means we are fully diversified across sector, size, and style, and for our bond fund, this means we hold bonds with a high-quality rating that are diversified across various terms. For example, holding a U.S. total market fund such as Vanguard’s Total Stock Market Index (VTSAX) means that we are essentially buying shares of the entire U.S. stock market; it contains a staggering 3,791 stocks, and is as diversified as it comes—at least considering the U.S. equity market.

There are two main considerations when it comes to diversification—and both are equally important: diversifying within asset classes, and diversifying across asset classes.

Continuing with our example, to further diversify, investors should look to the second consideration: adding asset classes with low (or no) correlation to U.S. stocks. This is where our decision to add an international stock fund as well as a bond fund comes in. Both of these asset classes have limited (or no) correlation to the U.S. stock market, and as such, will not mirror its movements. This means that your portfolio is designed to perform under different market conditions, and will not be solely dependent on the movements of one asset class. For example, stocks and bonds are inversely correlated, which means that typically (not always), when stock prices rise, bond prices fall and vice versa. Finally, selecting broad-market funds, such as Vanguard Total International Stock Market Index (VTIAX) and Vanguard’s Total Bond Market Index (VBTLX) will give investors broad-market diversification inside these new asset classes.

This second consideration is where I believe the popular strategy to invest solely in U.S. stocks breaks down somewhat. As noted above, a portfolio consisting only of a total U.S. market fund gains full diversity within the asset class, but fails to diversify across asset classes themselves. Said another way, investors in U.S. stocks are largely dependent on the health of the U.S. stock market in aggregate, because they have not diversified beyond it. In a sense, these investors have succeeded in not putting all of their eggs in one basket (Consideration #1), but have fallen short when we consider that baskets come considerably larger than just one country’s equity market (Consideration #2).

 …a portfolio consisting only of a total U.S. market fund gains full diversity within the asset class, but fails to diversify across asset classes themselves.

Breaking this all down leads us to this point: Having asset classes that all perform similarly in all market conditions—a high degree of correlation—is the opposite of what you want when considering diversification; in fact, it’s a good indication that your portfolio is not diversified enough. Having some parts of your portfolio lagging behind other parts, in my view, isn’t a weakness—it’s a sign that you’re well-diversified. 

Weighing In

We’ve covered a lot of ground. So, where does this leave us? Ultimately, investing internationally is a decision you will have to weigh out for yourself, but I hope I’ve given you some compelling reasons to at least consider international diversification. For me personally, I have chosen to invest 20% of my equities internationally, and here’s why.

First, I fully understand (and accept) the additional risks that international investing brings with it; I understand that my portfolio will be partially vulnerable to the political instability, different regulations, and accounting standards of other countries. I personally don’t find currency risk to be a significant factor long-term, and agree with John Bogle when he notes, “In the very long run, because the mechanics of government financing and international trade should equalize values, foreign currency risk relative to the U.S. dollar should be a neutral factor in global markets…I believe that the performance of foreign stocks for U.S. investors, in the long run, will be determined by each nation’s fundamental returns (based on dividend yields and earnings growth), rather than by currency returns” (Common Sense on Mutual Funds 255). In exchange for these additional risks, my portfolio will gain diversification outside of the U.S., and not be wholly dependent on the current state of the U.S. economy.

Second, I recognize the dangers that both recency bias and home country bias present to an investor’s portfolio. Regarding the former, I don’t believe I have the ability or knowledge to predict when the cycles of U.S-international outperformance will begin, and so I choose to angle my portfolio to account for both scenarios. Regarding home country bias, as you may have noticed, I have chosen to overweight the U.S. proportion of my portfolio (compared to a strictly global market cap weighted portfolio, which would invest 58% of equities in the U.S., and 42% in international equities). Said another way, I am allowing home country bias a slight foothold, and this is because I do believe strongly in the U.S. economy and its ability to provide strong returns over the long term. You may disagree: you may think a global market cap weighting is a more rational decision—or lean the other way, and believe strongly enough in the U.S. to invest all of your equities here. Either of these positions is perfectly understandable; my goal here is simply to encourage you to give thought to the decision of investing internationally.

But enough about my thoughts. Before you make the final decision for your own portfolio, here’s what the research arms of three of the major brokerages have to say:

  • Vanguard: A white paper published by Vanguard in 2008 notes that “domestic investors should consider allocating part of their portfolios to international securities and…a 20% allocation is a reasonable starting point…we have demonstrated that international allocations exceeding 40% have not historically added significant additional diversification benefits, particularly as costs are accounted for. For most investors, an allocation that falls between 20% and 40% should be considered reasonable, given the historical benefits of diversification” (Source: “International Equity: Considerations and Recommendations”).
  • Fidelity: “For a long-term investment portfolio, Fidelity recommends investors maintain a dedicated allocation to international equity.” They go on to suggest a “consistent 30% of the equity portfolio [your stocks allocation]” (Source: “Investing in International Equities”).
  • Schwab: “Depending on your return objectives and risk tolerance, your international allocation should be 5-25% of your total stock market investments and the international weighting necessary for truly global exposure is likely to increase over time as global trends become even more entrenched.” (Source: “Investing in International Stocks”)

Taylor Larimore has also provided an excellent synthesis of the leading pieces of advice mentioned above. Larimore concludes, “My suggested 20% is a compromise between the maximum 20% suggested by Jack Bogle and the minimum 20% recommended by a Vanguard study” (The Bogleheads’ Guide to the Three-Fund Portfolio 51). I agree with him.

Figuring Your Total Allocation

So, if you have decided to include international holdings in your portfolio, how exactly do you work that into your existing asset allocation? Remember, your international allocation is figured off of your overall allocation of stocks in your portfolio. An example will help clarify. Let’s say you’ve chosen an overall allocation of 80% stocks and 20% bonds, and want to allocate 25% of equities internationally. This would result in the following allocation:

  • 60% U.S. Stocks
  • 20% International Stocks (this is 25% of your overall 80% stocks allocation)
  • 20% Bonds

That’s all there is to it. Congratulations! You have now established your asset allocation, and taken a huge step towards building your portfolio. If you have been using the FFWF Investing Guide Checklist, write your final allocation down there. Also, let me know in the comments below what you’ve come up with! Now that we have the basic framework for your portfolio down, it’s time to move on to selecting the best individual funds that fit your asset classes. Up next in Part 11, we will be looking in-depth at how to research your fund options, and exactly which factors you should evaluate. I’ll also be providing a comprehensive list of the best funds I’ve found in my research. See you there!

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