Because different countries have different currencies, overseas travel is usually more complicated than domestic travel. Likewise, overseas investing is more complex than domestic investing. However, just as foreign travel adds diversity to your travel experiences, so foreign assets add diversification to your portfolio.
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.) 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.
Allocation of the Average Investor
According to a 2014 study from Vanguard, the average investor in the U.S. has 27% of their stocks allocated to foreign stocks. If the foreign stocks percentages seem high, remember that the U.S. holds only one-third of the world’s total stock market value. Which means 67% of the world’s stock market value resides outside of the U.S.
Global equities: Balancing home bias and diversification (15 Page PDF)
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 even though, according to a 2011 report, 75% of all the worlds bonds now reside outside of the U.S.
Global fixed income: Considerations for U.S. investors (20 Page PDF)
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 profit.)
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 investors have most of their bonds in U.S. bonds.
A Big Market
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.
Some investors hedge their currency risk by locking in a 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 foreign stocks that trade in the U.S. Investors purchase with dollars and receive their dividends in dollars. However, currency fluctuations do affect the performance of ADRs.
More than 2,000 ADRs from more than 70 countries now trade in the U.S., including ADRs from such well-known international companies as Toyota, Nestle, GlaxoSmithKline, Deutsche Bank, and Sanofi.
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 a good job diversifying into foreign 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 depends on that individual’s specific goals and tolerance for risk. But most investors would benefit by having a percentage of their portfolio allocated to overseas stocks and bonds.
These are the opinions of Financial Advisor 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.
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