Investors Confuse The Familiar With The
Safe
by Larry Swedroe
When ATT was broken up shareholders were given shares in
each of what were called the Baby Bells. A study done a short while later found,
however, that the residents of each region held a disproportionate number of
shares of their local regional Bell. Each group of regional investors was
confident that their regional Baby Bell would outperform the others. How else
can you explain each investor having most of their eggs in one baby basket?
Other examples of familiarity breeding investment are that Georgia residents own
16% of all Coca-Cola stock, and people in Rochester tend to own stock in Kodak
and Xerox. 1 This is not Lake Woebegone where
all Baby Bells can outperform the average of the group. This story is a good
analogy for the way domestic investors view non-domestic assets.
It seems to be a global phenomenon that most investors
hold the vast majority of their wealth in the form of domestic assets. While the
data is a bit stale, I don’t believe that much has changed. In 1990 the
domestic ownership shares of the world’s five leading stock markets was United
States 92%, Japan 96%, UK 92%, Germany 79%, and France 89%.2
With the relative freedom of capital to travel around the world, the lack of
global diversification cannot be explained by capital constraints. The only
explanation is that investors in each country believe that their domestic market
provides the best/safest investment opportunities. Investors in all five
countries were taking the unnecessary risk of having “all their eggs” in
their domestic basket, without any rational reason for doing so. It is simply a
behavioral issue.
A 1991 study found that the expected real return to U.S.
equities was 5.5% in the eyes of U.S. investors, but only 3.1% and 4.4% in the
eyes of Japanese and British investors, respectively. Similarly, expected
returns on Japanese equities was 6.6% in the eyes of Japanese investors, but
only 3.2% and 3.8% in the eyes of U.S. and British investors, respectively.3
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.
Academics, however, 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. A study published in the fall 1998 issue of the Journal of
Investing sought to determine whether international equity diversification
actually provided that theoretical risk reduction benefit.
The study covered the period 19701996. David Laster
examined the performance of portfolios with varying allocations to the S & P
500 Index and the EAFE Index. The study looked at portfolios with allocations of
10% S & P 500 and 90% EAFE, 20% S & P 500 and 80% EAFE, and so on. At
the end of each year each portfolio was rebalanced (correcting for market
movements) to its original allocations. Using a statistical method called
“bootstrapping” (creating a series of monthly returns using randomly
selected subperiods from the entire period), the study was able to effectively
examine far more 5-year holding periods than its 27-year period contained.
Before reviewing the results of the study it is important to note that during
this period the S & P 500 Index outperformed the EAFE Index by 12.29% to
12.03% per annum. In addition, the correlation of returns between the two
indices was 0.48, a fairly low figure.
The study concluded that:
- A combination of the S & P 500 Index and the EAFE
Index outperformed either index individually-a result of the low
correlation.
- Increasing the international allocation to as much as
40% increased returns and reduced risk as measured by standard
deviation (volatility).
- An allocation of 40% international produced the highest
Sharpe ratio-a measure of the amount of return for a given level of risk.
- Increasing the international allocation from 0% to just
20% reduced the likelihood of negative returns by one-third.
- Investors with a 10% international allocation could be
98% certain that they would reduce risk by raising the international
allocation.
- Investors with even a 22% allocation could be 90%
certain that they would reduce risk by raising their international
allocation.
What is likely to surprise most investors is that adding
international assets to a portfolio during a period when they underperformed
actually resulted in higher returns and lower risk.
Perhaps the most common argument I hear against
international investing is that the regulatory environment created by the SEC
makes the U.S. a safer place to invest. I fully agree that this is true.
However, before believing that you can benefit from this information you must
ask yourself if you are the only one that knows it. Obviously, the market is
aware of, and security prices around the world surely reflect, this
information.
Here is something else to think about. Perhaps one of the
contributing factors to the strong returns U.S. stocks have provided over the
last 50 years is the improvement that the SEC has made in its oversight of the
U.S. capital markets. It seems logical to conclude that this improvement has
contributed to the lowering of the perception investors have of the risks of
equity investing in the United States. The result was a lowering of the risk
premium investors demand. That resulted in a one-time capital gain, and
lower future expected returns (reflecting the now lower perceived risk). Now
applying that to foreign stocks you might draw the following conclusions. The
market knows that foreign stocks are riskier because of the more lax regulatory
environment. The market therefore prices for that risk and you get higher
expected returns as compensation. Let’s now speculate on the following
possible, if not likely, scenario.
The world has learned much about economic growth over the
past 50 years as capitalism has triumphed. In order to grow their economies
countries need access to capital. If a country does not have good disclosure
laws, investors simply won't provide capital. Therefore, I think it is logical
to conclude that the rest of the world will be moving to replicate U.S.
regulatory standards. In fact, many foreign companies are already adopting U.S.
accounting standards, as they want access to the U.S. capital markets. As more
international companies and foreign markets adopt U.S. regulatory standards the
risk premiums demanded for international stocks might fall as investors
recognize the change and lower their required risk premium. Investors in
international stocks would then realize a capital gain from the fall in the risk
premium.
Let’s assume that you believe that the U.S. is safer
(keeping in mind that investors in other countries also appear to believe that
their domestic market is safer) because the economic and/or political prospects
are better in the U.S. You should then conclude that the U.S. has lower expected
returns. This would not mean that the U.S. was a poor place to invest. However,
it is illogical to believe that the U.S. is a safer place to invest, while also
believing that the U.S. 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 percent 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 will lower living standards. Owning
foreign assets acts as a hedge against this risk.
Allocating a significant portion of your portfolio to
international asset classes will provide an insurance policy against potential
problems in the U.S. Since we don’t have a clear crystal ball, diversification
of risk is an important element of the winning strategy. If you need any more
evidence of this just think about Japanese investors in 1989. Like U.S.
investors in 2000, they may have seen no reason to diversify internationally.
Their economy was king. Their technology was dominating the world. Their managed
capitalism system was clearly superior to our more market oriented system. And,
the Japanese stock market had far outperformed the U.S. and other global markets
for 20 years. As we ended 2000, the Nikkei Index was still down approximately
70% from its level of over 11 years ago. Those who do not learn from history are
doomed to repeat the same mistakes.
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.
Sources:
1. Gus Huberman, Familiarity Breeds Investment, September 1999.
2. Kenneth R. French and James M. Poterba, “International Diversification and
International Equity Markets,” American Economic Review, vol. 81, No.
2, pp. 222226.
3. Gus Huberman, Familiarity Breeds Investment,
September 1999.
Larry Swedroe is the author of The Only Guide To
A Winning Investment Strategy You Will Ever Need and What
Wall Street Doesn't Want You To Know, available at amazon.com. He is also the Director of
Research for and a Principal of Buckingham Asset Management, Inc. in St. Louis, Missouri.
However, his opinions and comments expressed within this column are his own, and may not
accurately reflect those of Buckingham Asset Management.
Note: The featured
expert is solely responsible for the content of this article. The
opinions expressed herein are not necessarily those of MFI or BES,
Inc.
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