The Simple Way to Solve This Common Portfolio Problem

Doc's note: Today, our global expert Kim Iskyan explains one of the biggest problems you have in your portfolio... and the easy way to fix it.

For many people, there's no place like home. It's familiar and comfortable. That's true also of how most people invest: They stick to what they know – which is usually in their home market, language, currency, culture, and companies.

But for your portfolio, "staying at home" means taking on a lot more risk than you might realize. And in the evolving post-coronavirus world of vastly divergent economic growth and prospects, it's more important than ever to look around the world for the most attractive investment opportunities.

It's natural to want to invest in what you're familiar with – pretty much everyone around the world does. The average American with a stock portfolio has 79% of her money in U.S.-listed stocks. But American stocks account for only about 51% of total global market capitalization (that is, the value of all stock markets in the world).

That means that American investors are overly exposed to U.S.-listed companies – based on a breakdown of how much U.S.-listed stocks make up the world's markets.

It's not just Americans who are guilty of what's called "home-country bias." Investors in Japan put about 55% of their money in Japan-listed stocks – though Japan accounts for only 7% of the world's total stock market capitalization. Australians put 66% of their money into their domestic stock market – which is just 2% of the world's markets.

Why do investors do this? Besides the appeal of sticking to what they know, studies show that domestic investors tend to be more optimistic about their local economy. Also, local investors face fewer tax hassles when buying domestic shares and less foreign currency risk (that is, volatility in foreign exchange rates). And investors often trust companies and stocks outside their borders less than they do those in their own country (even if the "foreign" market is bigger and less volatile than the local market).

Over the long term, this causes serious problems for your portfolio diversification. Proper diversification ensures that you spread your investment eggs in different baskets and is critical to reducing the risk of your overall investment portfolio. Different markets outperform at different times. Even though most markets tend to move in the same general direction, having money invested in a range of geographical markets can boost your returns.

That's especially true today, as the global economy struggles to emerge from the quicksand of the coronavirus depression. Though economic growth isn't directly linked to stock market performance, it certainly sets the stage: And right now, the stage is looking very different across the globe, with the World Bank forecasting that China's economy will grow by 7.9% in 2021 – while the U.S. economy will increase by 3.3%, and Japan's by 2.5%.

To every rule about the value of diversification, though, there's an exception. And the past decade or so has been the big exception for investors in American markets – who have benefitted enormously from being "overweight" U.S.-listed markets.

Over the past 10 years, U.S. markets have trounced the rest of the world. During that period, a broad U.S. stock market index exchange-traded fund ("ETF") (represented above as the Vanguard Total Stock Market Fund (VTI)) returned a total of 264% (including dividends), as of the end of last year.

But investors in an "everywhere but the U.S." ETF would have made just 66%. And an emerging markets ETF – in which China, Taiwan, and India account for 70% of total holdings by geography – did even worse, rising a dismal 36% over the past decade.

The same huge performance gap between the U.S. and the rest of the world holds up for shorter periods as well.

What's more, the U.S. ETF has had just one down year in the past 10 (in 2018), while both the non-U.S. ETF and the emerging market ETF have seen four years of negative returns.

How much longer will this outperformance of American markets continue? There are as many inputs into how markets move, as there are investors. The only thing that's sure (as financier J. Pierpont Morgan is said to have unhelpfully declared when asked for a forecast about the direction of the market) is that markets "...will fluctuate."

But markets (along with most other things in life) tend, over time, to reverse extreme movements and gravitate back to average. It's like a rubber band... stretch it and when you let go it returns to its original shape.

So after a period of rising prices, markets tend to deliver average or poor returns. Likewise, market prices that decline too far, too fast, tend to rebound. That's mean reversion – and while it may take a while (witness the massive outperformance of U.S. markets), eventually it all tends to even out.

What's more, valuations – as measured by the price-to-earnings (P/E) ratio – suggest that it makes sense to look at markets outside the U.S. The VTI has a P/E ratio of 29 – compared with a relatively cheap 18 for the Vanguard FTSE Emerging Markets Fund (VWO). VEU, which is mostly developed markets in Europe and Asia (as well as 25% emerging market exposure) has a P/E ratio of 20. Over time, stocks and markets with a lower P/E ratio tend to outperform.

If you're wary, the best way to start investing internationally is via an ETF, which is as easy to buy as any stock. The Vanguard funds – like VEU and VWO – offer broad market exposure and low expenses, and are a great way to start... with your exposure contingent on your risk tolerance, where you are in your investment journey, and your other non-U.S. stock market holdings.

Elsewhere might not feel like home. But your portfolio will appreciate it.


Kim Iskyan

P.S. If you want to learn what investments Doc's team recommends in the international space, make sure you're signed up for Retirement Millionaire. Click here to get started today.