Leaving the Country

John Lim

ARE THERE TIMES when a near 100% international stock allocation makes sense? I believe there are—and that today is just such a moment.

Never in my life have I had such a low allocation to U.S. stocks. My overall portfolio is 60% stocks and 40% bonds. But the stock portion is comprised of just 15% U.S., with the remainder held in international stocks, split evenly between emerging and developed markets.

I realize that’s unorthodox. It would certainly be viewed as heretical by most financial advisors. But I believe there are four reasons to buck conventional wisdom:

1. The “traditional” international allocation is irrational.

It seems that most financial advisors and institutions recommend that international stocks account for 20% to 30% of a portfolio’s stock allocation. Like one of the 10 commandments, this advice has been handed down from on high and accepted without questioning. But is this recommendation actually evidence-based? Research by the Vanguard Group suggests that the benefits of international diversification, in terms of reducing volatility, plateau at around 40% foreign stocks. Further international exposure, Vanguard contends, leads to increased volatility.

Others have suggested using global GDP as a guide. Today, the U.S. represents 25% of global GDP, so following this line of thought would mean allocating 75% of a portfolio’s stock allocation to international shares. On the other hand, efficient market proponents suggest weighting a portfolio according to global market capitalization, which would mean holding about 44% in international stocks, since U.S. companies account for 56% of global stock market value.

No matter how you slice it, allocating just a quarter or so of a portfolio to international stocks makes little sense—and even less sense when considering today’s valuations, which I’ll get to shortly. Of course, investors aren’t machines. They need to be comfortable with their portfolios. It’s my contention that the low allocation to international stocks in large part represents home bias, the behavioral tendency to favor investments familiar to us and shun “foreign” investments (pun intended). Not only is this behavior irrational, I fear it could cost investors dearly.

2. The “global diversification through multinationals” argument is flawed.

Vanguard founder Jack Bogle was famously unconvinced that international diversification was necessary. He argued that investing in the S&P 500 provides sufficient diversification since so many U.S. multinationals have sizable global revenues. Fair enough.

This argument, however, can also be flipped on its head. By investing in international stocks, an investor gets significant exposure to the U.S. economy because the U.S. is a net importer of goods. If the U.S. economy thrives, so will the exporters that supply it with products such as textiles, commodities, cars and semiconductors.

In other words, the same argument that people use to justify a low international allocation can also be used to justify a far higher international allocation. But it’s at this point in the debate that someone inevitably raises the dreaded F word: “What about foreign exchange risk?”

3. Currency risk is overstated.

When U.S. investors hold foreign stocks, they have two exposures—one to the stocks themselves and the other to foreign currencies. If those currencies fall relative to the U.S. dollar—in other words, if the U.S. dollar strengthens in the foreign exchange market—that will lower the dollar value of foreign stocks for U.S. holders. This is what is meant by currency risk. This risk can be hedged and some funds that invest internationally do so, albeit at a cost.

Because investing overseas introduces currency risk, many investment professionals warn against having too much exposure to foreign stocks. But currency risk cuts both ways. Just as a strengthening dollar is a headwind to returns on international investments, a weakening dollar provides a tailwind—assuming currency exposure hasn’t been hedged.

Even if you shun international stocks altogether, you can’t completely escape currency risk in a globally interconnected economy. That’s because a depreciating dollar causes imports to become more expensive in dollar terms. This risk can be partly offset by owning international stocks, which benefit from a falling dollar.

More important, the currency risk associated with foreign investments may be overstated. According to Elroy Dimson, Paul Marsh and Mike Stanton, changes in foreign exchange rates largely reflect differential inflation rates among nations. If inflation in the U.S. is higher than in the Eurozone, the U.S. dollar would weaken relative to the euro by a similar magnitude. In fact, Dimson and his coauthors found that—in inflation-adjusted terms—the change in foreign exchange rates has averaged less than 1% per year since 1900. They concluded, “This has important implications for long-run investors, as it means they are already protected to some extent from currency risk.”

4. U.S. stocks are in a bubble.

The most compelling argument for overweighting international stocks today is valuation. Historically, U.S. and international stock markets have had quite similar returns, close to 7% a year after inflation. But historical returns and expected returns are two distinct animals.

As I argued recently, expected returns from U.S. stocks are abysmal. Based on valuations and the tendency for asset classes to mean revert, the coming decade may be another “lost decade” for U.S. stocks. By any number of metrics, the U.S. stock market is in bubble territory. Ratio of total market capitalization to GDP? That would be 200%, the highest in recorded history. What about the cyclically adjusted price-earnings (CAPE) ratio? It’s at 38, a level only once surpassed, at the height of the tech bubble in 2000.

Some argue that rich valuations are justified by record low interest rates. Maybe. But why are European stocks far less expensive, despite even lower interest rates? And what happens to stock prices if interest rates finally begin to levitate from today’s moribund levels?

If you believe, as I do, that U.S. stocks are in bubble territory, does it still make sense to own them in the name of diversification? Does adding a “bubble asset” to your portfolio lower risk or increase it? Put yourself in the shoes of a Japanese investor in late 1989. Despite nosebleed valuations, you decide that Japanese stocks will form the core of your stock portfolio. How did that work out for you? You didn’t need a crystal ball to realize how poor the risk-return proposition for Japanese stocks was in the late 1980s. Instead, all you needed to do was look at valuations. I believe the same is true today for U.S. stocks.

If expected returns for the U.S., developed international and emerging stock markets were similar, I’d happily diversify across global markets, holding a good chunk of U.S. stocks in my portfolio. But that’s not the situation we find ourselves in today. Due to the immense outperformance of U.S. stocks since 2009, the outlook is far brighter for foreign markets. Price matters. And I’d argue that today price trumps diversification when it comes to portfolio construction.

Should stock markets mean revert and U.S. stocks underperform international shares over the coming decade—as I fully expect they will—I’ll happily return to owning U.S. stocks. As John Maynard Keynes purportedly said, “When the facts change, I change my mind. What do you do, sir?”

John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.

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