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Do I need to have money invested in other countries to properly diversify my portfolio?

Is the US enough or am I taking on more risk by investing in US assets?

Jul 13, 2015 by Daniel in  |  Flag
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While I believe that you should have a home country bias to the U.S. since your liabilities are in the U.S., there are advantages to investing in other countries. As Randy mentioned, the correlation with U.S. assets is one possible advantage as it can lower the overall volatility of your portfolio. Exposure to countries with faster GDP growth is one benefit. Adding currency diversification is another potential benefit, but it's also a potential risk. Currency risk can be mitigated with funds that are currency hedged.

There are sometimes regional advantages to certain industries as well. Mining, for example, is an industry that benefits from geographic diversification. Operations in South America, Africa, and Australia may more fruitful than anything we can produce locally due to natural geology. This regional difference may extend to other industries as well.

I believe that it's important to have exposure to both developed foreign countries and emerging markets. This is for both debt and equity investing. However, you should have measured amount of each and actively manage these allocations as there can be a large difference in returns. For example, EAFE (foreign developed) was down 4.90% in 2014, emerging markets were down 2.2%, while the S&P 500 was up 13.69% in 2014. A good tactical manager may be able to use these return variances to your advantage.

Comment   |  Flag   |  Jul 14, 2015 from Austin, TX

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Most people suffer from “home bias” when constructing their portfolios (you can Google “home bias in investing” to learn more). Thus, it is likely that you have 80% of your assets in U.S. stocks and bonds. Note that while the U.S is 22% of global GDP, the European Union is 24%! The U.S stock market is less than 40% of global equity market cap. Meanwhile, people in Japan often have 80% of their money in Japanese stocks and bonds. We can go all over the world, and people are widely overweight the assets of their home country. Yet history often treats home biased investors rudely over time.

Don’t believe me? Think back to the late 1980’s when Japan seemed to be taking over the world. Their GDP was growing by 6% per year, their stock market was averaging over 20% per year, and Mitsubishi had just purchased Rockefeller Center. Who wouldn’t have wanted 80% of their assets in Japanese stocks and bonds? Yet they suffered through a multi-decade deflation that saw their stock market fall a whopping 70%! A world neutral approach would have saved the Japanese investor. Just last year the Russian stock market dropped 50%. What happened to the average Russian investor?

World neutral investing is all about creating an investment portfolio that takes advantage of all of the investing options open to you, and does not focus on where you happen to reside. World neutral investing is all about diversification, and diversification is all about correlation. Diversification is not about how many different positions you have in your portfolio. Many people will say “I have large cap U.S. growth stocks, large cap U.S. value stocks, small cap U.S. growth stocks, and small cap U.S. value stocks, so I am diversified.” This fails to acknowledge that those four assets are very highly correlated (usually over 90% correlation). Thus, if one is up or down 20%, then they likely are all up or down similar amounts.

Correlation is widely under-appreciated in investing, yet it is one of the most important factors to consider. Think about the U.S. stock market. Over time, it has averaged around 9% per year. But year-to-year it fluctuates wildly. Just since the year 2000 the S&P 500 has had two calendar years of losses over 20%, and three calendar years with gains over 20%. That is five times in 15 years! Has your portfolio been swinging around wildly over the last decade? That is one sign you may have not embraced world neutral investing in a prudent manner.

Over the last five years (2010-2014), U.S. equities have only been 30% correlated with emerging market equities (as opposed to an 87% correlation with developed international equities). Gold has had a -69% correlation with U.S equities over that time span. Correlations are really important to consider when creating an investment portfolio.

If you have two assets in your portfolio with 9% expected returns, but they are highly correlated, your portfolio will likely bounce around similar to the returns of U.S. equities mentioned above. But if your two assets are negatively correlated, you will have cut your portfolio volatility and will likely get much closer to 9% returns each year.

World neutral investing is all about diversifying, reducing correlations, and reducing your portfolio risk.

Comment   |  Flag   |  Jul 13, 2015

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Daniel...I agree with Richard. In that the short answer is yes. There are 3 simple rules to successful investing. Own equities and high quality short term fixed income...GLOBALLY diversify...Rebalance. This is a formula of successful investing speculating is another matter.

Comment   |  Flag   |  Jul 14, 2015 from Green Bay, WI

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Daniel, I firmly believe that diversification does require international exposure. That being said, you need to know what you are invested in and what you are adding to your portfolio when you try to determine your level of diversification. What I mean, if you currently own a typical S&P 500 index fund you already have significant international exposure. According to a recent Goldman Sachs quote, about 1/3 of the S&P 500's revenue came from foreign sales. You'll really need to review the positions you own when determining what international positions are needed to increase diversification.

Comment   |  Flag   |  Jul 15, 2015

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Frank Reilly Level 20

Even though international investments may be risky themselves, having an allocation to them in your portfolio does increase the diversification and can slightly reduce the risk of the portfolio as a whole.

Comment   |  Flag   |  Jul 23, 2015 from La Mesa, CA

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This video may help answer your question as to diversification. For specific recommendations ask your Financial Pro

https://www.youtube.com/watch?v=2Rbe16o0r04

Comment   |  Flag   |  Aug 05, 2015 from Omaha, NE

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Richard P Taylor Level 17

Daniel, the short answer is yes. A properly diversified portfolio would have some exposure to international both equity and debt. That being said, exactly where internationally and how much is a question that can only be answered by someone who knows your entire financial picture. With that being said, the point of diversification is never to own enough of anything to make a killing, thus you never own enough of anything to killed by it. I wish you all the best.

Comment   |  Flag   |  Jul 14, 2015

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I fall into the "international" investing offers diversification benefits and better risk adjusted returns. However, it is worth noting that AAII Journal (American Association of Individual Investors) recently removed all international investments from their model portfolios. They are a respected journal that tends to offer really good articles and objective advice. While I don't necessarily agree with them on this issue, it worth bringing up that there are experts out there that do not think foreign investing is required. If I had a client that insisted on no foreign investments, I would have no problem accommodating their request. Correlations between foreign and domestic markets have increased over time, an increasing amount of revenue in the large stocks is generated from over seas sales, and in times of panic, the correlations of all risky assets tend to go up (hurting the diversification benefits). So to answer your question, yes I do think its smart to add international, however, if you felt strongly that you did not want to, I see it reducing risk but not nearly to the magnitude increasing your bond exposure does.

Comment   |  Flag   |  Jul 15, 2015

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Daniel, I would like to add to the discussion and offer a slightly different view. There is something called "blind diversification" which lacks an understanding of the why as to how asset classes behave and relate to one another.

While international diversification is important, it is important to understand the risk and return drivers. In other words, is the risk that you are trying to diversify shared? It may be helpful to dissect your portfolio into the four primary market exposures or asset classes (E.g. Bonds, Equities, Currencies and Commodities - Note Alternative Investments are strategies and not a separate asset class). Each primary market has its own unique risk and return drivers. With that said, however, certain drivers may be shared across different - think of equities and credit markets that are both sensitive to the business cycle and economic growth landscape. Going into a recession, both will likely not perform as well as in a growing economic backdrop. Hence, the reason high yield bonds are correlated to equities as an example. Proper diversification will seek to minimize the co-movements/correlation and shared drivers across various asset classes.

Within equities, there is an opportunity to diversify within the asset class. This may be prudent so as to have a diverse exposure to various business cycles across the globe as well as different capitalization spectrums as smaller companies may be able to grow at faster rates than larger companies. There may be compelling growth and valuation characteristics offering more tactical opportunities from time to time as well. While one country/region may be weak, there may be others that are performing well for various reasons. Geographic diversification can therefore be achieved by directly investing in foreign securities or indirectly through domestic (U.S.) companies that sell into growing foreign markets.

Within bonds similar rationales apply as one can diversify business and monetary cycles for example. A useful consideration if looking at foreign bonds is to determine the types of market exposures that make sense for your unique needs and objectives. What currency, rate and credit risk are you willing to assume? The idea behind diversifying internationally within bonds is that the risk and return drivers are not going to be exactly the same as within the U.S. and for that reason it may be beneficial to include some foreign bonds so long as the risk-reward characteristics are in your favor.

Commodities tend to have certain shared drivers of risk with bonds and equities. However, returns can also be impacted by currencies as well as demand/supply imbalances and the nature of how one accesses commodities either through futures markets, physical ownership or exposure to producers as a few examples. Often times, because many commodities are priced in U.S. dollars in global markets, there is an indirect currency exposure that can cause commodities to weaken as the U.S. dollar strengthens as a general relationship and assuming everything else equal.

You are asking an important question and hopefully the answers provided in this discussion help illuminate the path for you better as it pertains to international diversification. The key is not to blindly diversify but really understand the underlying fundamental drivers that help explain asset class behavior. One cannot rely on historical parameters entirely. Rather, it is important to have a proactive forward looking view of the world to help design portfolios with the desired characteristics given various scenarios with an understanding of how different asset classes may share different risk and return drivers.

Comment   |  Flag   |  Jul 20, 2015 from Rockville, MD

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Laurie Itkin Level 2

There are so many low-cost exchange-traded funds (ETFs) that can capture high-quality, dividend-paying stocks of companies in Europe. If you are going to invest in blue-chip, dividend-paying US stocks, you'll find that some of the companies in the UK, Germany, etc pay higher dividends than U.S. companies. There are also many ways to capture the potential growth of emerging markets. With the plethora of ETFs, there is no reason not to have international exposure. We live in a global economy.

Comment   |  Flag   |  Jul 24, 2015 from La Jolla, CA

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