Yes, Yes, Hmmm

Jonathan Clements

SOCRATIC DIALOGUE, anyone? Today, we’re tackling three questions. Almost all HumbleDollar readers will, I suspect, readily answer ”yes” to the first two questions—and balk at the third.

1. Are markets efficient? We can debate just how efficient the market is. But most readers, I suspect, will agree that the financial markets are sufficiently efficient that there’s no easy way to score market-beating gains—especially once we factor in the investment costs involved.

It’s the brutal logic of investing: Before costs, we collectively earn the market’s return. After costs, investors—as a group—must inevitably earn less. Could you overcome your investment costs and earn market-beating gains? It’s highly unlikely. The financial markets attract the best and brightest, who spend every day scouring the markets for an advantage. Result: If there are bargains to be had, they don’t stay that way for long.

That’s one of the reasons this site is called HumbleDollar. Our judgment of market values is unlikely to be better than the collective judgment of all investors, as reflected in market prices, so we favor a humbler approach: buying and holding market-tracking index funds.

2. Should you weight stocks based on their market capitalization? Some index funds equally weight the stocks they hold. Others weight stocks by fundamental measures of value, such as total sales, earnings, cash flow and dividends.

Still, most index funds weight stocks based on their total stock market value. This makes sense: If you believe the collective judgment of all investors, as reflected in market prices, is wiser than any one individual, why would you second-guess the market’s judgment and use a yardstick other than capitalization to weight stocks?

This doesn’t preclude overweighting certain market sectors, like small-company shares, value stocks and emerging markets, because you think these market segments are riskier and hence have the potential to deliver higher market returns.  It’s the same risk-reward tradeoff that might drive you to allocate more overall to stocks, while downplaying bonds. But once you’ve made these basic decisions about how much risk you’re willing to assume, it makes rational sense to accept the market’s judgment—and buy stocks according to their total market capitalization.

3. Should you put 48% of your stock portfolio in foreign shares? That’s the allocation to foreign stocks for Vanguard Group’s total world stock index fund, which seeks to replicate the performance of the entire global stock market. In other words, that’s the value that investors worldwide have collectively assigned to foreign stocks.

If you’re an indexer who is happy to piggyback on the judgment of other investors and hence who favors weighting stocks by their market capitalization, that 48% in foreign stocks should be the default allocation. But many U.S. investors—including many indexers—are far below that level, often keeping just 20% of their stock portfolios in foreign shares, and sometimes less.

To be sure, you might keep less than 48% of your stock-market money in foreign stocks if you’re worried about currency risk. But consider an alternative approach: Keep 48% of your stock-market portfolio in foreign stocks, but allocate part of your foreign stock money to an index fund that hedges its currency exposure. For instance, you could buy a fund like iShares Currency Hedge MSCI EAFE ETF (symbol: HEFA).

To be sure, the fund levies 0.35% in annual expenses, which strikes me as rich. But even if the fund charged just 0.1%, I suspect many hardcore indexers would still resist allocating half their stock market money to foreign shares. That suggests their objection to international investing isn’t really about the currency risk involved.

So what lies behind their resistance to foreign stocks? I’ve heard all kinds of arguments against investing abroad: that property rights aren’t as firmly established, that corporate accounting isn’t as trustworthy, that insider trading is more prevalent. But if markets are efficient, wouldn’t these concerns be reflected in share prices, so investors are rewarded for taking the added risk involved?

Similarly, I’ve heard investors claim there’s no need to buy foreign stocks, because U.S. companies get so much of their sales and earnings from abroad. But by the same token, many foreign companies have substantial operations here. Does that mean U.S. stocks are riskier than perceived—after all, who knows what those dastardly foreigners might do to our good ol’ American companies—while foreign multinationals are less so?

I’m not arguing that everybody should have half their stock portfolio in foreign shares, though that’s what I’ve settled on for my own money. But if you aren’t at 48% or anywhere close, and you’re a firm believer in efficient markets and in indexing, you should ask yourself why. Can’t come up with a good reason? Maybe it’s time for some portfolio changes.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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