Formed in 1963, the venerable Magellan Fund helped raise investor awareness of international investing during the 1970s. During the 1980s, there was a big push in the investment-management community to convince investors to diversify their portfolios globally. All these years later, do the classic arguments for international investing remain valid?
While the answer is yes, there are still good reasons to favor U.S.-based stocks in your portfolio -- especially today.
Arguments for international investing
Here are three of those classic arguments for international investing:
1. To be more representative of the global market. On a capitalization basis, U.S. markets represent just over one-third of all publicly traded stocks in the world. So, the argument goes, if you limit yourself solely to U.S. stocks, you are playing the game in just one-third of the field.
2. To reduce risk through diversification. Stock performance varies from country to country, so by diversifying internationally you can reduce portfolio risk by having a chance of holding investments in some countries that are doing better when the U.S. is down.
3. To capture emerging market growth. The U.S. has a very mature economy, while countries in earlier stages of their development tend to have more dynamic growth. Investing internationally is a way to capture some of that dynamic growth.
Many U.S. investors have no or limited international stock allocations in their portfolios. Investment professionals tend to blame this on a home-country bias -- the reality that it is always easiest to invest in one's home country, and investors tend to be more comfortable with familiar companies.
It does make sense to break free of this home-country bias, but should you reduce your U.S. holdings to about a third of your portfolio, in keeping with the U.S. share of global market capitalization? There is an argument to be made that you should not go that far. When it comes to the U.S., there may be good reasons for retaining some degree of home-country bias.
Why a U.S. investment bias makes sense
While diversifying internationally is well worth considering, when it comes to a discussion of country bias, it should be acknowledged that the U.S. occupies a unique position on the global financial stage. This may well justify a larger allocation than its share of global capitalization.
1. Currency risk. When you invest in a foreign market, you have to worry not only about the performance of the individual stocks or markets you invest in, but also the direction of that country's currency relative to the U.S. dollar. You could hedge this with currency trading, but that introduces a whole other level of complexity and expense to your investment program. While even domestic investments are affected indirectly by currency fluctuations, international investments intensify this risk.
2. The "big dog" effect. The notion of reducing risk by diversifying with foreign stocks works better for investors in other countries than for U.S. investors. Why? The U.S. is the big dog in the global economy. When the U.S. economy is doing poorly, it tends to drag other stock markets down, diminishing (though by no means eliminating) the diversification benefit of foreign investments.
3. Liquidity. The U.S. stock market is by far the world's biggest, at about five times the size of the next largest. When it comes to being able to trade stocks efficiently even during times of investor distress, the U.S. has an advantage over most other countries.
4. Relative strength. This is a situational rather than systematic reason for maintaining a heavier weighting toward U.S. stocks: The U.S. economy is running pretty well right now, while much of the rest of the world is struggling.
5. Interest rate environment. As low as they are in the U.S., interest rates are even lower in some other countries (especially relative to inflation). Falling interest rates tend to boost stock prices, but once rates are already low, you should be concerned that the inevitable bounce-back in rates will create a headwind for stocks going forward.
6. Credit risk. Switching to the bond side of the portfolio, U.S. Treasuries carry less credit risk than the government bonds of many other countries -- something to keep in mind in the wake of repayment failures by countries such as Argentina and Greece.
7. Political risk. It is easy to take for granted the institutional stability and rule of law in the U.S., but don't expect similar protections everywhere you invest. There are good reasons to avoid investing in certain countries.
If you ignore non-U.S. investments altogether, you can be accused of home-country bias. However, if you decide to maintain a majority position in U.S. stocks, it may well be the result of a reasoned investment decision.
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