U.S. equity investors, acting like individual investors all over the globe, own portfolios that are almost exclusively domestic-oriented. Investors are seemingly avoiding the diversification benefits provided by low-correlating asset classes. The following are four explanations typically offered for the failure to diversify (or only diversify minimally) beyond domestic borders.
- The most often heard rationale is that international investing is risky. All equity investing is risky. However, U.S. investors are probably mistakenly overconfident about the relative prospects of the U.S. market relative to other markets. Behavioral finance studies have found that a common error among investors is to mistake the familiar with the safe. U.S. investors are more familiar with U.S. equities than foreign equities, and thus, assume they are safer. Confusing the familiar with the safe, French, United Kingdom, German, Swiss and Japanese investors all think that their economies are the safest. Even if the U.S. is the safest, that does not mean that you should have all your eggs in one basket. Investors should never make the mistake of confusing even the highly likely as certain (i.e., we buy life and fire insurance because we want to avoid making that mistake). As one example, Japanese investors in 1989 were probably thinking that Japan was the safest place to invest. As another example, we can look at the 20-year period 1970-89 and find that while the S&P 500 Index returned 11.6 percent, the EAFE Index returned 15.2 percent.
- The very same investors who believe that the U.S. is the safest place to invest also seem to believe that U.S. stocks will provide the highest returns, an illogical conclusion - unless you think the whole world is mispricing equities. Since risk and expected return must be related in a rational world, how can safe investments provide higher expected returns than risky ones?
- Another oft-stated reason for avoiding international equities is that you can gain all the international exposure that you need by investing in U.S. large-cap stocks, as they are mostly multinational companies with plenty of international exposure. The problem is that U.S. multinational stocks, while having exposure to foreign economies, trade mostly like U.S. stocks. They don't trade like foreign stocks.
- A common reason for avoiding international equity investing is that it entails another type of risk, currency risk. First, currency risk is not a bad risk. It is a different type of risk than equity risk or small or value risk (which have expected risk premiums as compensation). Currency risk has no expected return, hence, no risk premium. However, adding currency risk provides a valuable diversification benefit against domestic fiscal and monetary policies. For example, domestic inflationary pressures are usually bad for domestic bonds and stocks, and often lead to currency depreciation. Owning "currency risk" provides a hedge against such outcomes. In effect, what most investors don't seem to understand is that as a U.S. investor only investing in domestic companies, you are taking currency risk - only you don't know it. The risk is that the dollar will fall in value, deteriorating your cost of living. A falling dollar will not only lead to rising import costs, but also to rising prices from domestic competitors who are no longer faced with competing with cheap imports. This can also lead to rising inflation overall. This is what happened in the 1970s and early 1980s - and it can happen again. Owning international assets diversifies currency risk. Owning only U.S. stocks doesn't avoid currency risk. The risk is still there, only in a different form. If the dollar rises in value, it is likely that foreign equities will underperform (hence, the currency risk). However, if the dollar falls in value, the cost of maintaining your lifestyle will rise. The difference is that in the first case (rising dollar), the risk shows up on your balance sheet. In the latter case (falling dollar), it doesn't. However, the risk is there nonetheless. The lack of visibility is one reason currency risk is misunderstood.
The Benefit of Diversification
Financial economists recommend that investors add international assets to their portfolios, because they actually reduce risk. The reason is that international equities do not move in perfect tandem with domestic equities. Hedging currency risk would increase the correlation of returns, and the higher the correlation, the lower the diversification benefit. However, hedging currency risk does reduce the volatility of the asset. And the impact on volatility is greater than the impact on correlation of returns. The result is that hedging actually produces a very small reduction in overall portfolio volatility (though the reduction is statistically insignificant).
A study covering the period 1988-2003 found that hedging currency risk between the Russell 3000 and EAFE increased correlation of returns from 0.61 to 0.71. However, the standard deviation (volatility) of a 60 percent equity (30 percent Russell 3000 and 30 percent EAFE) - 40 percent fixed income portfolio would have been reduced from 8.84 to 8.73. Thus, the impact of hedging on volatility was greater than its impact on correlation of returns. However, there is the simple logic of not having all your eggs in one basket, no matter how safe that basket may appear. Bruno Solnik explains that, "Foreign currencies provide an element of diversification against domestic budgetary, fiscal and monetary risks. For example, domestic inflationary pressures are usually bad for domestic bonds and often lead to currency depreciation. In this scenario, an inflationary rise in interest rates is also bad for domestic stocks, although it is good for foreign currencies. [Thus we can conclude that] Although the value of foreign currencies is volatile they bring some risk diversification to domestic portfolios."
In their paper, "Behavioral Portfolio Theory," Hersh Shefrin and Meir Statman offered the following observation. "The distinction between foreign stocks and domestic ones is an illustration of the distinction between risk, where probabilities are known, and uncertainty, where probabilities are not known. Familiarity with a security brings the situation closer to risk than to uncertainty. Uncertainty averse investors prefer familiar gambles over unfamiliar ones, even when the gambles have identical risk."
Investors shouldn't make the mistake of confusing familiarity with safety. An important component of a prudent investment strategy is having a significant portion of the equity allocation being devoted to international markets, and the currency risk should be unhedged.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.