After deciding how much of your portfolio should be in each asset class (stocks, bonds, commodities, etc.), the next asset allocation decision to make is how much of your portfolio should be invested in your own country’s stock market and how much should be invested abroad.
Weighting by market capitalization
A common sense starting point would be to weight each country’s stock market according to its current market capitalization. That is, do the same thing with countries that index funds do with companies: Weight them according to size.
Most figures I’ve seen indicate that the U.S. stock market makes up just under 40% of the value of the entire world stock market capitalization.
Therefore, to have U.S. stocks make up any more than 40% of the equity portion of your portfolio is to bet that the U.S. stock market will outperform non-U.S. markets. (It’s analogous to holding an index fund that tracks the Wilshire 5000, then holding some additional shares of Exxon Mobil (XOM) because you’re convinced it will outperform the rest of the market.)
Most (U.S.) advisers, however, recommended that investors hold from 70-90% of the equity portion of their portfolios in U.S. stocks–far more than the 40% that would be justified by a market-cap-weighting strategy.
Even more fascinating is that this same phenomenon occurs in countries around the world. The phenomenon of investors over-weighting their own countries is known as home bias.
The most commonly cited reason for home bias is that, in general, the more familiar we are with something, the more confidence we have in it. (This is also one of the reasons cited for why investors are comfortable holding extremely out-sized portions of their portfolios in the stock of their own employers.)
Why home bias is potentially a problem
With picking stocks, in order to outperform the market, you need to know something that the market doesn’t know. The same thing applies to picking countries.
And in each case, it’s unlikely that individual investors are privy to information of which the market is unaware. As a result, it makes a certain degree of sense to simply invest in each country in proportion to its market capitalization.
Taking Currency Into Consideration
In my opinion, however, there is a good reason for an investor to over-weight her own country in her portfolio. It comes down to currency. Regardless of where you live, you probably pay for almost everything you buy using the currency of your own country.
Consider what would happen if early in your retirement your own currency experienced a dramatic increase in value relative to other currencies and you were stuck holding a portfolio made up primarily of companies from other countries.
Those stocks would be plummeting in value (as measured in your own country’s currency). As a result, you’d end up having to liquidate an artificially high portion of your portfolio to pay your bills–even if your living expenses hadn’t increased at all.
It would seem logical to me to take a market-cap-weighted allocation as a starting point and adjust your domestic allocation upward slightly. It would also seem wise to move more of your portfolio into domestic assets as you get closer to retirement.
What do you think? What would you say to somebody who argued in favor of holding the bulk of your portfolio in international assets?