Is now a good time to start international investing?
Photo: Victor Hancek. Source: Picjumbo
Most investors have a home-bias in their portfolio. That is, they own a higher percentage of domestic stocks than a globally diversified portfolio would indicate. This is true for folks who tout indexing as well as for active managers who pick stocks. US-based investors prefer US stocks; UK investors prefer shares listed in London; Japan-based investors prefer Japanese stocks, and so on.
There are several reasons behind this. Familiarity bias means we prefer what we know to something we haven’t heard of before. This holds true in many areas of life, not just investments. Localism also means we tend to “root for the home team,” so we’re over-optimistic about the growth potential of our home country. Availability affects investors – it can be hard to purchase many good companies because of the costs of setting up accounts overseas, and they may not have shares listed here. And risks of overseas investing can be overstated. Foreign companies are often listed as among the riskiest investments, despite the well-documented risk reduction that global diversification brings.
In the US, investors today also experience recency bias: what has happened most recently is assumed to be the normal state of things. For four of the last five years, the US has done better than the rest of the world, and over this period it has done dramatically better – growing 6% per year more than non-US markets.
So is this the time to go global, and shift some of those high-performing US assets to overseas markets? The inverse question is also relevant: is this the time UK or Japan-based investors who have US-domiciled assets to “come home,” or at least reduce their exposure to US equities? After all, mean-reversion is a well-studied phenomenon: trees don’t grow to the sun, and markets can’t diverge forever. If markets mean-revert, non-US markets should eventually do better that the US.
A lot of people also point to relative market valuations as a red flashing light. High P/E or P/B ratios can’t head higher forever. But when you consider the recent financial performance of US markets, the ratios don’t seem especially out of line.
Source: Morningstar, 361 Capital
The US is about 50% more expensive than Emerging Markets or Asia, but it’s ROE (return on equity) and ROA (return on assets) are about 50% higher. It’s about 10% more expensive than Europe, but its financial performance has been about 10% better. In only one area the ratios for the US raise concerns: it’s debt-to-capital, which is also elevated. That’s arguably a lot higher because of US tax policy, which favors corporations’ issuing bonds to buy back equities. In the long run, an elevated debt-to-capital ratio creates more risk. But the biggest debt issuers also have large cash deposits frozen in overseas accounts – another factor driven by tax policy. Still, a higher debt level increases risks for equity investors, who have fewer rights if something goes wrong.
In the end, the strongest case for diversifying globally doesn’t come from anticipating returns but from reducing risk. “Give portions to seven, even to eight, for you do not know what disaster may come upon the land” (Eccles. 11:2). US markets have been strong, and may continue to be strong. But the US economy isn’t the only source of wealth in the world.
Douglas R. Tengdin, CFA