In market moments like these, it’s always tempting do something really big and bold with our investments.
Here’s a bad idea that’s likely to occur to the fight-or-flight animal within all of us: Scale way back on stocks in parts of the developed world with economic woes and put the proceeds someplace far, far away, in emerging-markets stocks or gold or foreign currencies.
It’s clear why this is tempting. After all, there are too few grown-ups at all levels of government who are willing to both scale back programs and raise the taxes we need to pay for them. Standard & Poor’s, in fact, expressed its own disillusionment on Friday night by taking the long-term sovereign credit rating of the United States down a notch.
Meanwhile, in Europe, it seems that with each passing week another country is at risk of not being able to make good on its debt.
If you’ve lived through these swoons before, however, you know that few knee-jerk investing strategies born of uncertain times prove to be anything but total bunk. But this particular bit of lunacy is useful for the question it raises about the optimal amount of money to bet on your own country. The answer: leave more at home than your animal instincts would suggest right now.
Let’s start with a few givens. First of all, no parking money on the sidelines. You will read a lot about “investors” going to cash, but they are among a couple kinds of people.
There are professionals, who aren’t investing for the long run. Then, there are individuals who don’t realize that most investors who bail out end up selling at low prices and getting back in again after prices have spiked.
Most of us should be the third kind of investor, the one who rebalances by selling the winners in well-balanced portfolios and buying the losers after large percentage declines.
The second given is this: we believe in stocks. For those of us who have a time horizon longer than a decade or two and lack a trust fund or a fat pension, a portfolio made of anything other than a hefty proportion of stocks stands a good chance of not earning enough over time. Low returns necessitate unpleasantries like doubling savings, working much longer or living on less in retirement.
And a third given: We’re talking about index or other passively managed mutual or exchange-traded funds here. Tracking individual stocks requires too much work and adds too much risk of underperforming the various market indexes.
As for whether you should run scared from your investments in the United States and Europe, the most natural initial question is this: Why bother investing outside of these regions when global markets seem to move in tandem?
There are three reasons. While it is true that global markets move up and down together with more similarity than they used to, returns are not identical either. As a result, owning stocks around the world should decrease your overall volatility, which can help returns.
Second, there’s currency diversification, which helps at times like these when the American dollar is weak. And finally, there is industry diversification in things like manufacturing, which you don’t get as much of from some developed-market companies as you used to.
While our hair-trigger strategy from up above suggests that familiarity with the United States and much of Europe ought to breed contempt with their stocks now, the reverse has historically been true. Investors exhibit “home bias,” owning a collection of stocks from their own country that is out of proportion to that country’s ranking in the global market.
In the United States, this results partly from our smug feeling of singularity in general. But it may also be a comfort thing.
“They know Wal-Mart, but when you show them Petrobas or a company with another funny sounding name, there is some uncertainty,” said Mike Palmer, a principal with the Trust Company of the South in Raleigh, N.C. “People like certainty in their investment portfolios. But we don’t know where the next Wal-Mart is.”
In fact, American investors exhibit the least amount of home bias on earth according to academic research by three professors, Sie Ting Lau, Lilian Ng and Bohui Zhang. (The homebody awards go to investors in the Czech Republic and Peru.)
Still, the professionals in the United States who move the most money around tend not to match the market exactly.
The value of American stocks makes up roughly 40 percent of the world’s stock market, but you won’t find many target date mutual funds with 60 percent of their stocks in international investments.
Fidelity increased the international portion of its stock collection to just 30 percent in 2009. Vanguard followed suit in 2010. Even Dimensional Fund Advisors, a company built on academic research about the efficiency of markets, has just 40 percent or so of its stock money in international securities in its mutual funds that allocate assets for investors.
Why not match the 60 percent allocation that truly represents international stocks’ share of all stocks on earth?
Vanguard notes that the higher expenses of investing outside the United States can affect returns. Dimensional points to taxes — some countries withhold them and that can reduce returns for many American investors.
Rick Ferri, author of “All About Asset Allocation” and founder of the money management firm Portfolio Solutions, has had his clients’ international stock allocations fixed at 30 percent for 12 years.
He notes that given all of the business that American companies do outside the country, anything more than 30 percent may not reward you with the returns you would want as compensation for the fact that many emerging-markets stocks bounce around more than others.
That said, emerging-markets stocks have returned a bit more than others historically in exchange for their wild swings. So wouldn’t now be a good time to make a big bet on their stocks? Or certainly their currencies, since the dollar may remain weak?
“If you’re certain that the dollar has to go down from here, the market is going to be aware of it and account for all of those beliefs already,” said Chris Philips who works in Vanguard’s investment strategy group. “You’re going up against hedge funds and professional traders.”
And even if you have a bright idea before they do, betting on countries is tricky. Consider a Dimensional Funds commentary that’s been making the rounds among the rational recently. (I’ve linked to it from here in the online version of the column.)
The article notes that ratings agencies ranked Indonesia’s sovereign debt in the junk category for all of the last decade, though it has improved some. Despite the supposed uncertainty, however, its stock market’s total return has been 33 percent a year in dollars.
There are probably not a lot of people who made big stock bets in Jakarta, though. There are even fewer, if any, anywhere on the planet, who found all the Indonesias and can pick them again in the future.
And that’s why humble investors spread their bets around the globe, avoiding both home bias and the kind of home-country self-hatred that times like these can too easily breed.