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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.

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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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ishabaka
ishabaka
2 months ago

In essence, this is a market timing prediction.

Mr Moderate
Mr Moderate
2 months ago

I have some in DGS, though you may not like the expense ratio.

Kurt S
Kurt S
3 months ago

I usually have about 30% in international stocks. Every January around half of that 30% was put into the worst-performing stock market the previous year. In 2020 that was Brazil. EWZ on a total return basis is up 5.8% so far in 2021. Not great. Not bad. That is the game I play.

Mik Cajon
Mik Cajon
3 months ago

I personally choose to not own any funds/stocks that invest in China…for obvious reasons.

Kurt S
Kurt S
3 months ago
Reply to  Mik Cajon

I take it a step further. If it says “Made in China” I don’t buy it.

Pravin Mittal
Pravin Mittal
3 months ago

John, Thanks for such a great article. Yes, I do have 40% of my stock portfolio in International. I also tilt my portfolio to a small cap. However, I like to understand how are people are allocating the Bond and cash part. What strategy and funds are they using?

Purple Rain
Purple Rain
3 months ago
Reply to  Pravin Mittal

VTIP, I-Bonds (directly from Treasury Direct)

Roboticus Aquarius
Roboticus Aquarius
3 months ago

John, you make some excellent points. You may want to invert your thesis and then consider whether to rebalance your conclusions. A few points:

  • Many US investors place a premium on the highly developed capital markets and regulation that they believe contributes to US market strength and stability, as well as it’s dynamism.
  • The projected returns you speak of have a huge standard deviation. Note that ten years ago, every prediction was also for poor returns going forward. Since then, the S&P500 has returned 14.5% annually (nominal CAGR) assuming dividend reinvestment.
  • The US is the world’s reserve currency. Currency disasters would seem to be less likely in the US than in many other nations.
  • The US is not Japan. We have a robust and creative economy that is relatively free of government interference compared to most economies, especially when it comes to our banks. (There are caveats, but on balance I believe this is true.)
  • Yes, high Cape ratios appear to be driven by higher interest rates. And changes in revenue & expense recognition. And changes in the structure of the average business (far less capital intensive.) And their global reach. For starters.
  • US investors will mostly be spending their retirement in the US, spending US dollars. The biggest error for such an investor may be hitching their investments to other countries that fail to keep pace.
  • International is a broad brush. You could also say: Ex-US developed countries, Emerging Markets, and even Global Small Caps, though the US piece of that is more of a reach.

All that said, about 45% of my equities are international, and have been for a long time. I do believe in international diversification. I also believe in holding a *close to* market portfolio for much of my holdings, and any tinkering happens around the edges, such that I’m unlikely to ever hold more than 50% international, or less than 40%. Even so, I found this discussion entertaining and enlightening; I appreciate this challenging viewpoint.

jpayne0880
jpayne0880
3 months ago

Thanks for the article. I was looking at my Vanguard account today through Portfolio Watch and noticed 3 alerts. One was to further diversify my portfolio with an allocation of 30-50% foreign stocks. Second, to allocate 20-50% of bonds to foreign bonds.

Perhaps these alerts have been up for a while, but I thought it was interesting after having read this article and figured I’d share…

Purple Rain
Purple Rain
3 months ago

It’s demographics. Asia and Africa have the youngest populations and the fastest growing middle classes, therefore the greatest future productivity and growth.

Philip Stein
Philip Stein
3 months ago
Reply to  Purple Rain

Careful here. The superior demographics of Asia and Africa are well-known and are likely already reflected in securities prices.

Guest
Guest
3 months ago

Thank you for your article Mr. Lim. I too increased my international equity allocation, particularly in emerging markets. I settled on VWO for my emerging piece which is a large blend because I’ve had a tough time finding my preferred choice which is purely emerging value. Any reader suggestions in that department would be much appreciated!
Cheers

johntlim
johntlim
3 months ago
Reply to  Guest

Dodge & Cox recently opened a new Emerging Markets (value) fund (DODEX). They are a fine shop, one which the late Jack Bogle deeply admired.

Purple Rain
Purple Rain
3 months ago
Reply to  Guest

DFCEX has a tilt towards smaller cap and lower valuations. It is offered in several rertirement plans.

David Powell
David Powell
3 months ago

Am now also a fan of higher int’l stock index allocation and in March last year shifted mine higher. The broad US market and SP500 are expensive by many measures. Value segments seem closer to long term averages so I’ve focused new US equity index money there. Still, wouldn’t mind another short/deep correction.

Brandon Beckett
Brandon Beckett
3 months ago

I always like John Lim articles. Thought provoking. I do a 20% international allocation mainly because that seemed like what people were recommending on bogleheads.

The international allocation suggested here feels like very bold advice. Much of the rationalization comes from the high CAPE. The CAPE is something I struggle with. Some authors treat it like dogma and adjust their holdings because of it. But other authors write that basically it stopped working as a predictor as soon as it was discovered. The market isn’t a math problem. There is no guarantee that it will do what you expect based on a math problem. It is an irrational morass of human emotion. Maybe valuations are high, but what if the US market keeps rocketing up for 5 more years before it reverts to the mean. I mean, a few days ago, when the market dropped just 1ish %, there seemed to be plenty of dip buyers yet. Or, with reopening of businesses and improved earnings, won’t the P/E ratio improve anyways, without a massive bubble burst.

Philip Stein
Philip Stein
3 months ago

How valid is comparing the CAPE ratio from ten years ago to the value today? I think many would agree that today’s post-pandemic economy is very different from the economy of 2010 and earlier.

How confident can we be interpreting a historically high CAPE ratio in the face of an evolving economy? I don’t know. Any thoughts?

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