Foreign stocks and bonds provide diversification for your portfolio, helping to smooth out any ups and downs in it.
With a Gross Domestic Product (GDP) of over $17 trillion, the United States has, by far, the world’s largest economy. (China has the second-largest, with a GDP of $10 trillion.) Moreover, 49% of the world’s stocks and 44% of the world’s bonds are based here in the U.S.
It is therefore understandable why individuals living in the world’s most dominant country prefer to invest here, given their allegiance to the so-called “home-team bias.” This bias, however, may prevent individuals from realizing the benefits international stocks and bonds would provide to their portfolios.
According to a 2014 study from Vanguard, the average investor has 27% of their stocks allocated to foreign stocks.[i] If the foreign stocks percentages seem high, remember that the U.S. holds only one-third of the world’s total stock market value. This means 67% of the world’s stock market value resides outside of the U.S.
A second 2014 Vanguard study, this one focusing on bonds, confirmed what I see in my practice: most U.S. investors have very little exposure to international bonds,[ii] even though, according to a 2011 report, 75% of all world bonds now reside outside of the U.S. [iii]
The home-team bias appears to be more pronounced with bonds than with stocks. This is surprising, since the reasons for investors to allocate a percentage of their portfolio to foreign stocks, such as asset allocation and diversification, should apply to bonds as well. (Asset allocation and diversification strategies cannot assure a profit.)
When individuals invest in overseas stocks or bonds, they rub up against the world’s largest market—the currency market. According to the Bank for International Settlements, foreign-exchange trading volume averages $5 trillion per day, while the entire U.S stock market trades about $191 billion per day.[iv]
Because different countries have different currencies, overseas travel is usually more complicated than domestic travel. Likewise, overseas investing is more complicated than domestic investing. However, just as foreign travel adds diversity to your travel experiences, so foreign assets add diversification to your portfolio.
Some investors hedge their currency risk by locking in time and price at which they can sell or purchase a currency. Hedging, however, costs money. An investor must pay a fee to a counter-party—an institutional investor, corporation, government, bank, or currency speculator—for the right to buy currency from them or to sell a currency to them.
Investors who enjoy owning individual stocks but want the added diversification of foreign stocks can incorporate American Depositary Receipts (ADR) into their portfolios. ADRs are international stocks that trade in the U.S. Investors purchase with dollars and receive their dividends in dollars. However, currency changes do affect the performance of ADRs.
More than 2,000 ADRs from more than 70 countries now trade in the U.S.,[v] including ADRs from such well-known international companies as Toyota, Nestle, GlaxoSmithKline, Deutsche Bank, and Sanofi.[vi]
There are many ways for individual investors to get exposure to foreign stocks or bonds—and, if you believe the Vanguard studies, the average investor has done an excellent job diversifying into international stocks. However, those same investors have not done the same with foreign bonds.
Of course, there is no such thing as an “average investor,” and everyone’s asset allocation and diversification depend on that individual’s specific goals and tolerance for risk. However, most investors would benefit by having a percentage of their portfolio allocated to overseas stocks and bonds.
With 40% of the profits of the firms listed in the S&P 500 stock index now coming from overseas sales, some financial professionals believe that investors get plenty of diversification by owning stocks of U.S. multinationals. This theory, however, fails to explain why bond investors have most of their portfolio in U.S. bonds.
[i] Christopher B. Philips, CFA, “Global equities: Balancing home bias and diversification,” Vanguard.com, February 2014. Retrieved from http://www.vanguard.com/pdf/ISGGEB.pdf
[ii] Christopher B. Philips, CFA, et al., “Global fixed income: Considerations for U.S. investors,” Vangaurd.com, February 2014. Retrieved from http://www.vanguard.com/pdf/icrifi.pdf
[iii] QVM Group, LLC http://qvmgroup.com/invest/2012/04/02/world-capital-markets-size-of-global-stock-and-bond-markets/
[iv] Bank for International Settlements website, http://www.bis.org/
[v] U.S. Securities and Exchange Commission Office of Investor Education and Advocacy, “Investor Bulletin: American Depositary Receipts,” August 2012, www.investor.gov. Retrieved from http://www.sec.gov/investor/alerts/adr-bulletin.pdf
[vi] “Equity Investor Marketplace,” UBS, http://eqi.ibb.ubs.com/equityinvestor/en/UBS/underlyings.html
These are the opinions of Tim Hayes and not necessarily those of Cambridge. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice.