Say Goodbye To Your Home Bias

Includes: EFA, EWC, SPY
by: Dale Roberts

U.S. investors have some 72% of their investments at home. The U.S. equity markets represent over 35% of the total world equity markets by value. The U.S. economy represents some 20% of the total world economy. That leaves a lot of unexplored or under-utilized investment opportunities for U.S. investors who practice that home bias.

Why do most investors display a home bias? Familiarity. We all like investing in companies that we can see and touch. We like companies that we see advertisements for and with products that we see on the store shelves. But there's a price to be paid for the comfort level that comes from familiarity.

Now may be the time more than ever for U.S. investors to say goodbye to their home bias. U.S. markets are more popular than ever and have recently reached all-time highs in price terms. The U.S. markets are generally ranked as modestly overvalued with respect to historical averages. At best some pundits will describe the U.S. markets as fairly valued. True (out of favor) value may be found in other markets and in companies domiciled in other countries.

Of course the U.S. markets underperformed many of the developed international markets for an extended period. And this would perhaps be the number one reason to get rid of your home bias. From 2000 and through the financial crisis to 2009 the U.S. markets underperformed to a very large degree.

Above we see the S&P 500 (NYSEARCA:SPY) in blue delivering no gains except for dividends from 2000 through 2008. We also see the International Index EAFE (NYSEARCA:EFA) posting gains of 100% (plus dividends) from the inception date of mid 2001. Having a strong player on the bench deliver while another player is in a deep slump can have a few advantages.

Here's a time frame with the Canadian markets (NYSEARCA:EWC) and EAFE charted against the S&P 500. That is obviously an incredible outperform of non U.S. markets over that time period.

As I demonstrated in this article investors can prosper from international diversification. The international markets, EAFA, and the Canadian markets also outperformed the U.S. markets from September 2003 and into 2013. Holding a diversified portfolio that offers times of price protection (total portfolio value) can have its obvious benefits.

If an unexpected life event forced you to sell some funds, and you had a home bias (when home was underperforming) you might be forced to sell some assets at a loss. Conversely, if one needed funds and held the international holdings, one could take profits and turn that profit into the required spending money, or might consider turning those profits into income from bonds or CDs. There's a real benefit to portfolio price protection. There are times when total return is more important than any other measure.

Another major benefit of holding an internationally diversified portfolio is investor psychology. Most investors don't have the stomach for seeing their portfolio value fall precipitously. A diversified portfolio would have allowed an investor to stay in positive territory through much or most of the lean years of the U.S. markets in the period shown above.

Many U.S. investors feel that they are covered on the international fronts due to the fact that many American multinationals generate a large degree of their profits overseas. Even U.S. dividend growth investors who exhibit a home bias may be putting their portfolios and dividend growth in jeopardy. In response, I wrote this article - Sorry your dividends are not coming home any time soon. And currency protection from U.S. multinationals? Not really. Here's the overview from my article on currency exposure through holding U.S. multinationals.

Let's do some quick math. For every dollar invested in the "average" multinational, 40% of profits are derived from foreign operations. We're at .4. Half of those are funds are repatriated. We're at .2. If those foreign profits are repatriated and face the 35% tax rate we're now at .13, or a potential 13% direct currency hedge or exposure.

In the end, there's not a great degree of currency exposure to be had from those multinationals. If you're concerned at all about the U.S. dollar and prolific money printing, you might want to add some true currency exposure.

And of course U.S. investors are not alone with respect to investing with a home bias. It is an international practice. Like many Canadians I have had a very pronounced home bias - personally from 2000 through to present. I am still working my way through that attempting to add more international EFA and U.S. exposure. But I got lucky with my home bias as the Canadian markets outperformed the U.S. markets perhaps to an ever greater degree than the broader international markets outperform. But I have to admit again that it was luck and not by design. To be able to predict which markets will outperform over any given time period is likely nearly impossible.

Here's a look at the Canadian index in green vs the U.S. S&P 500. While a U.S. investor certainly does not want to over-expose to a small market such as Canada, one might want to consider adding 5-10% Canadian exposure.

While the S&P 500 has hit new highs other major markets have been sputtering or at least languishing. As we all know buying solid companies and markets when they are undervalued (and that usually happens when they are under appreciated and out of favor) is the time when we can make some very generous returns over the longer term. Of course, we can't predict when a certain market or region will come back into favor, but we do know that the major stock markets of the world generally return to their long-term average or historical rate of return.

European and international stock markets were certainly out of favor in recent years, but have delivered some very generous returns over the last year or more. In fact EAFE would be the top performer of the last 15 months, of the three indices from this article.

Canadians display the same home bias that is common around the world, but the Canadian stock markets represent a mere 3% of the international markets. Canadians are leaving much of the 97% of the global opportunity on the table. Canadian markets and the international index have been underperforming the U.S. indexes coming out of the recovery.

Over this time period (above) Canadians and investors around the world who did not have healthy exposure to U.S. markets have paid the price. Just as U.S. investors with a home bias had portfolios that underperformed in that period from 2000 through 2008.

Investors never know when, or what market is going to have a period of underperformance or outperformance.

Open up your investment horizons to new lands. Allow your investment strategy to travel. To echo the sentiments of parents who have 30-somethings still living in the basement ... "It's time for you to leave home".

Disclosure: I am long EFA, DIA, EWC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. Streetwise Portfolios offer the lowest-fee, managed, index-based portfolios available to Canadians. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.