Guest post featuring Larry Swedroe, author of Investment Mistakes Even Smart Investors Make.
When AT&T was broken up, shareholders were given shares in each of what were called the Baby Bells. A study done a short while later found that the residents of each region held a disproportionate number of shares of their local regional Bell. Each group of regional investors was confident their regional Baby Bell would outperform the others. How else can you explain each investor having most of their eggs in one baby basket?
Larry Swedroe, explains that investors tend to view domestic stocks as safer and better investments than international counterparts:
One study found the expected real return to U.S. equities was 5.5 percent in the eyes of U.S. investors, but only 3.1 percent and 4.4 percent in the eyes of Japanese and British investors, respectively. Similarly, the expected return on Japanese equities was 6.6 percent in the eyes of Japanese investors, but only 3.2 percent and 3.8 percent in the eyes of U.S. and British investors, respectively. Familiarity breeds overconfidence (or an illusion of safety), and lack of familiarity breeds a perception of high risk.
Many investors avoid adding international investments to their portfolios because they believe international investing is too risky. However, academics recommend that investors add international assets to their portfolios because they actually reduce risk. International equities do not move in perfect tandem with domestic equities. Therefore, the addition of international stocks to a portfolio should reduce the volatility (risk) of the overall portfolio.
Let’s assume that you do believe the United States is safer because the economic and/or political prospects are better. You should then conclude the United States has lower expected returns. Although this would not mean the United States was a poor place to invest, it is illogical to believe the United States is a safer place to invest while also believing the United States will provide higher returns. Risk and expected reward should be related.
There are other arguments for including international asset classes in a portfolio. U.S. investors have all of their intellectual capital in the domestic market. Their ability to generate income from employment is tied to U.S. economic conditions. They also might own a home, which may constitute a large percentage of their assets. If the dollar falls in value on the currency markets, not only will the cost of imports rise, but the competitive pressures from cheap imports will also decrease, allowing domestic manufacturers to raise prices. This combination of events could lower living standards. Owning foreign assets acts as a hedge against such risk.
Investing in international equities surely involves risk, but so does investing in domestic equities. And the evidence suggests that including international equities within a portfolio reduces the overall risks of the entire portfolio. Think about it this way: Diversification is a form of insurance. And we only insure against bad things. International diversification provides us with insurance in case the U.S. capital markets and the dollar perform poorly.
Larry E. Swedroe is the bestselling author of the The Only Guide series and other successful investment guides. He writes the blog “Wise Investing” for CBS MoneyWatch.com and speaks frequently at financial conferences. He is also a principal and Director of Research for The Buckingham Family of Financial Services which includes Buckingham Asset Management and BAM Advisor Services.