How Much Should I Invest Abroad

by Guest Contributor · 8 comments

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.)

“Home Bias”

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.

In Conclusion

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?

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{ 8 comments… read them below or add one }

Aaron May 8, 2009 at 1:13 pm

Interesting to think about home bias. However, my question is how does one even get into international investing? Can you just go through your normal broker?

Another factor to consider is that although US has only about a 40% market cap, isn’t there something to be said for its reliability? I feel like it’s far more regulated than other markets, and hopefully means its a safer investment. So to me it doesn’t seem illogical to weight your portfolio a little more heavily towards more stable markets.

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ObliviousInvestor May 8, 2009 at 1:38 pm

Hi Aaron.

As to how to go about diversifying internationally, yes, any brokerage firm should give you access to plenty of international mutual funds (index or otherwise).

And, I’d argue that it’s simply our familiarity with the U.S. that makes it feel more stable to us (at least, as compared to any number of other developed countries).

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MoneyNing May 8, 2009 at 3:48 pm

Aaron: You may be thinking about the emerging markets when you think about international but there are actually many different markets that are quite big and stable.

Furthermore, the US market might be stable traditionally but with the S&P jumping 5+% every single week for a while now, I don’t think that’d be considered “stable” at all.

Like Oblivious Investor said, many ETFs, ADRs and funds give you international exposure and you can always opt for something like Etrade Financial (here’s an Etrade review) where they have a international broker division that lets you trade stocks in foreign markets directly.

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MoneyEnergy May 9, 2009 at 1:49 pm

Exactly as MoneyNing and Oblivious said: many, many markets are stable. It’s just parochial US bias that might lead one to think otherwise. Also, any company that trades as an ADR in New York has already met the standards required for the NYSE. I would also say that Canada is a foreign market and Canada’s economy has been one of the most stable throughout the downturn, and more US investors should realize this.

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Slinky May 11, 2009 at 11:04 am

Good article. I agree that people should have more international investments than most do. The currency point is very valid and a good thing to consider though.

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Blogging Banks May 18, 2009 at 7:01 am

MN,

Did you know that the top 10 companies in the S&P 500 by market cap generate about 40% of their revenues from abroad? If this sample size tells us anything it is that by adding international funds to our stock portfolio, we are overdiversifying our international exposure.

Here’s the link to the study ( sorry to post an outside link):

http://www.dividendgrowthinvestor.com/2008/12/international-over-diversification.html

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ObliviousInvestor May 18, 2009 at 7:08 am

BB, you bring up a great point: It’s tricky to know exactly what level of international diversification you have just by looking at where your companies are based.

I’d caution, however, against calling it overexposure to international markets. Remember, the issue goes both ways: Many of the companies that make up international index funds have very large portions of their revenues coming from the U.S.

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justin etheridge February 4, 2010 at 6:17 pm

oh lord im confused can someone please talk to me in english and help me undrstand what to do with my 401k.. uuuuggghh, please send me a email.. thanks for any help.

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