It’s a common investing pitfall… Folks often focus their investments on the country where they live.
In fact, the average American investor holds a little more than three-quarters of his portfolio in stocks listed on U.S. exchanges. American stocks, though, account for only about half of total global stock market capitalization (that is, the value of all the world’s stock markets put together).
That means that most Americans are “overweight” U.S. stocks – they own more American stocks than an allocation based on market capitalization would suggest.
This tendency for investors to favor stocks in their domestic market is called “home-country bias.” For Americans, this seems like a logical choice… The U.S. is a big and powerful country, and the world’s largest economy, so it should indeed make up a good portion of anyone’s portfolio.
But perhaps surprisingly, whether they live in the U.S., Germany, or Singapore, investors all over the world are “overweight” their home country.
These days, investors in Japan put about 55% of their money in Japan-listed stocks – although Japan accounts for only about 8% of the world’s total stock market capitalization. And Australians put 66% of their money into their domestic stock market – which is just 2% of the world’s market capitalization.
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Those data don’t even include real estate… For many people, buying a home is their single largest investment, and it’s nearly always a “home country” purchase. The same is true of most folks who buy real estate for investment purposes. So including real estate, the actual concentration of investors’ assets in their local markets is actually much higher.
If your home country struggles to grow – or, worse yet, undergoes a serious crash – you just may be stuck in a bad situation.
Whether you’re a tycoon making big financial moves, or a wage-earner trying to buy a home to live in, what happens to your country, happens to you.
Now I’m not calling for a massive market crash here in the United States, but certainly many of the ingredients have already been mixed together… high government debt, low interest rates with no inflation, an aging population, and a speculative bubble.
But here’s the key… The modern financial system has given you a way to protect yourself. Many folks think of the stock market and other investments as a way to get rich without working. And sure, that’s part of it. But perhaps more important is the ability to spread your assets around all parts of the economy, and the world, to earn safer returns and protect your wealth from changes to one single sector, economy, or currency.
A century ago, a miner’s entire fortune rose and fell with the mining industry. Today, workers in, say, health care, can set themselves up to gain from technology, energy, and global industries.
That’s what we’re going to do today.
The Risks of ‘Staying Home’ With Your Portfolio
I get it… If you’re going to be living in the same place for a long time, maybe forever, it might make sense to have most (or all) of your assets in that country. If you live and work in the U.S., what’s wrong with holding all of your assets in American stocks, bonds, and dollars?
Here’s the thing… You’re putting all of your eggs in the same basket. What if the banking sector goes bust? What if your home currency massively devalues? What if the real estate market crashes or the government starts searching for ways to plug a massive budget deficit, and your assets are all in that country?
That might sound more like something that would happen in an emerging market like Russia or Indonesia – not the U.S. But it was barely a year ago that the U.S. stock market fell an emerging-markets-like 34% in about a month. In April 2020, the U.S. unemployment rate exploded by more than 10 percentage points, as nearly 16 million people lost their jobs due to the COVID-19 panic. The U.S. economy shrank by one-third in the second quarter last year.
Currently, the U.S. dollar is the world’s reserve currency. But looking forward, unprecedented spending by the U.S. government, and debt issuance from the Federal Reserve, will increasingly call into question the status of the U.S. dollar.
As of March 1, just over three-quarters of all dollars that have ever been printed were created over the previous year. The federal deficit is forecast to hit 15% of U.S. gross domestic product (“GDP”) in 2021 – the biggest deficit since World War II. That compares with a deficit of just 2.4% of GDP as recently as 2015.
None of this means that the U.S. economy, the U.S. dollar, or U.S. stock markets are headed for a collapse tomorrow… or even anytime soon.
The wealth gap in America has never been wider — we’ve still never fully recovered from the Great Recession of 2008, and it’s only going to get worse from here. But the effects of the Big Con are going to devastate those who don’t take action. So do something now while you still can.
But for your portfolio, “staying at home” by investing in what you know means taking on a lot more risk than you might realize. The United States won’t forever be the dominant power that it has been over the past many decades. It only makes sense to hedge your bets by putting some of your investments in other markets.
And in the evolving post-COVID-19 world of hugely divergent economic growth and prospects, it’s more important than ever to look away from home – and outside the scope of what you know from immediate, first-hand experience – for the most attractive investment opportunities.
Of course, there are reasons people stay home. And some of them make sense. But we can find ways to get abroad and stay smart…
The Comfort of Home
Sometimes, it makes sense to invest in something that you don’t know that well.
That’s heresy to an entire generation of investors who came of age following legendary investor Peter Lynch’s advice to “invest in what you know.”
From his perch as the portfolio manager of Fidelity Investment’s Magellan Fund – for years the world’s largest mutual fund – Lynch urged regular investors to apply insight they gleaned from their professional or personal experience to their stock investment decisions.
Investing in what you see with your own eyes and experience in your regular day, as Lynch suggests, has some advantages… The steelworker might note an increase in shifts at his plant, the fast-food diner might spot long lines outside one particular chain, and the parent might know which big-box stores have the fullest parking lot.
This philosophy promotes sticking to the familiar and comfortable. And that’s how most people choose investments… in other words, what they know.
Lynch’s advice echoes that of legendary investor Warren Buffett, who warns investors to “never invest in a business you cannot understand.” It’s a lot easier to understand a business that you have direct experience with… that’s conducted in a language you understand… and is run by people who come from a similar culture.
What’s more, investors tend to be more optimistic about their local economies and markets than foreign investors. Investors tend to trust companies – that the interests of management are aligned with those of small shareholders, and that corporate governance will be sound – inside their borders, more than they do companies outside their own country. And by staying local, investors face less trouble come tax time, and much less foreign-currency risk.
Many investors are wary of foreign markets anyway. It’s one thing to invest in a company based in your country whose products you see every day. It’s something else entirely to put your money into a company or market that’s on the other side of the world, in a place you’ve never been… and take a leap of faith that you won’t be ripped off.
If your home base is relatively affluent and stable, the volatility – that is, sharp price swings – of less developed markets might be unfamiliar. Getting enough information to make an informed investment decision – to at least come close to the standards of Lynch and Buffett – might feel impossible.
However, we can simplify things…
First of all, investing in a foreign company is not so different from buying domestic stocks. Business is business, the world over. If you invest in profitable businesses that delight customers and grow responsibly, you’ll generally do well. Research shows that the concepts of valuation and profitability apply in all markets.
And many top emerging market stocks are actually very familiar to most investors in the U.S. Think Taiwan Semiconductor, whose computer chips power many of our devices, gadgets and electronics… or South Korean electronics giant Samsung.
Those are products you use and know. Doesn’t it make sense to have some investment in them?
As far as tax issues and stock selection, we can use index funds to take care of the tricky issues. And if you are concerned about political stability, we solve that problem by diversifying across countries.
What may be more vital, though, is that today looks like the ideal time to put some capital into emerging markets…
Performance Travels Around the Globe
Different economies and markets outperform at different times. Investing in a range of geographical markets can boost your returns.
Take Japan, for example… The Japanese stock market index was at approximately the same level in 1987 as it was in 2020. Today, the country’s index trades well below the all-time high it hit in December 1989. (By contrast, the S&P 500 Index is around seven times higher than its 1987 levels.) Japanese investors who “stayed at home” over the past several decades have missed out in a big way.
Of course, a well-performing market can continue to rise, as evidenced by the historic bull run of the S&P 500 (more on that in a moment)… just like a poorly performing one can suck wind for a long time. Just ask investors in Japan how that felt.
But at some point, mean reversion kicks in – that’s when the pendulum swings back… when extreme movements, one way or the other, tend to reverse and trend toward a long-term average.
In market terms, that means that after a period of rising prices, a well-performing market tends to deliver average or poor returns. And markets that have been long-term laggards will – all else equal – get their time in the sun again.
Diversification is not only a smart way to insulate your portfolio against the damage of a few eggs in your basket being broken… It also helps improve your portfolio’s performance.
While U.S. stocks have soared over the past decade – and more – those in emerging markets have massively underperformed, as shown in the table below…
Over the past year (as of April 30), both U.S. and emerging markets are up around 50%. That huge jump follows the global market correction as the severity of the coronavirus rose to the front of investors’ minds.
But looking to three-, five- and 10-year performance, you see a huge divergence. American markets have boomed, while emerging markets – the biggest of which include China, Taiwan, South Korea, and India – have dramatically underperformed.
Over the past five years, U.S. markets – represented above by a broad index of nearly 4,000 traded stocks – have risen a total of 125.6%… while emerging markets are up 73.1%. And over the past decade, American stocks are up 271.8% – compared with just 36.5% for emerging markets.
And now – after an extended run of strong performance – U.S. markets are more highly valued than emerging markets. Two of the most widely used ways to gauge how “expensive” a market is are the price-to-earnings (P/E) ratio, which compares the share price to the company’s earnings per share… and the price-to-book (P/B) ratio, which reflects the value of a company’s assets minus the value of its liabilities, per share.
And right now, emerging markets sport a P/E of 18, compared with 29 for the all-U.S. stock index… That means U.S. stocks are 61% more expensive. Emerging market stocks trade at a P/B of 2.3, compared with 3.9 for the U.S. – a 70% premium for American stocks.
Admittedly, valuation and the “cheapness” of a stock or market make up only one part of the story. Cheap stocks can remain that way for a long time. And sometimes, an asset is cheap for a reason.
It makes sense for higher-risk emerging markets to be at least somewhat cheaper than U.S. markets… But that doesn’t mean you should avoid emerging markets entirely. Right now, the premium of U.S. markets is close to all-time highs – far higher than warranted. And the pattern of mean reversion argues that emerging markets are due to outperform U.S. stocks in the coming years.
That doesn’t suggest you should go crazy. No matter what, it’s probably a good idea to keep your portfolio’s exposure to emerging markets relatively limited – say, somewhere between 5% and 15%, depending on your risk appetite… when you’ll be needing your investment capital… and your overall time horizon. It’s also an argument for a well-diversified approach to investing in emerging markets.
A Hassle-Free Bet on Emerging Markets
What we’re looking for is a way to diversify outside U.S. markets… to capture the valuation discount of emerging markets… and to benefit from mean reversion as American stocks eventually slow down and shares in emerging markets play catch-up.
There are lots of ways to do this. And what I recommend today is the iShares MSCI Emerging Markets ex China Fund (Nasdaq: EMXC).
EMXC is a broadly diversified exchange-traded fund (“ETF”) listed on the Nasdaq stock exchange. While it holds foreign stocks, this fund is easy to buy and sell.
This emerging markets fund holds nearly 600 stocks across 13 countries. Its biggest geographic exposures are Taiwan (at 23.1%) and South Korea (21.6%). Taiwan and South Korea are two of the most dynamic economies on Earth… In many ways, these two markets look a lot more like developed markets than emerging ones.
For example, in terms of economic output per capita, both South Korea (at just under $32,000) and Taiwan (at $31,000) are higher than Portugal ($23,000), even though Portugal is considered a developed market. Still, they don’t meet all of index-maker MSCI’s requirements to be classified as developed markets, so they’re still considered emerging markets from an investment perspective.
As you’ll see in the chart below, the rest of the countries represented in the EMXC portfolio are more traditional emerging markets, including India, Brazil, South Africa, and Russia. These are all markets that offer tremendous opportunity – but also come with more risks than South Korea or Taiwan.
Next, let’s look at EMXC’s individual stock holdings…
Its two biggest are Taiwan Semiconductor and Samsung… We mentioned both earlier.
Taiwan Semiconductor manufactures more than half of the world’s semiconductors, which are a critical ingredient in everything from electronics to computers to smartphones.
Samsung, the second-biggest position, makes a wide variety of electronics for consumers and industrial customers alike – most famously, cellphones.
As the table below shows, other individual holdings make up 2% or less of the total fund…
What About China?
Now, one obvious question that I’m guessing is at the tip of your tongue: Why are we buying a fund that explicitly excludes China?
Just to be clear… I believe China is an attractive market that is worthy of some allocation in your portfolio.
But I’m more focused on diversification. In broad emerging markets funds, China’s mainland and Hong Kong exchanges make up around 35% to 40% of the holdings… and that allocation could rise to nearly 50% in coming years, as the number of Chinese shares that are included by MSCI rises. That’s a heavy allocation to a single country in an index.
What’s more, the Chinese economy is the world’s second-largest, after the U.S. – and the aggregate size of its stock markets are closing in those in the U.S., too. Increasingly, China’s economy and markets are rapidly shifting to look a lot more like those in the developed world – and soon it will be a stretch to refer to China as an emerging market at all.
For all those reasons, I think China deserves its own separate allocation to your portfolio, as a China-focused fund or via a small collection of stocks. (My colleagues Steve Sjuggerud and Brian Tycangco have a newsletter dedicated to China and other emerging markets… click here to learn about a subscription.)
But for our purposes here, I’d prefer an emerging market fund that isn’t overshadowed by China… and EMXC – whose ticker means emerging markets excluding China – fits the bill.
A Little Diversification Goes a Long Way
A lot of people are wary of investing in faraway markets. But you should also be more wary each time you put another dollar into the same markets that define your entire portfolio, home value, and income stream.
It makes a lot of sense to diversify outside of your home market. And that’s still true if your assets are heavily concentrated in the U.S… even if you never have plans to leave the home of the stars and stripes.
Mean reversion alone suggests that it’s a good idea to put some money in other markets – because U.S. shares won’t continue to hugely outperform other markets (and emerging markets in particular) forever.
And finally, we can do it simply as a smart bet on a group of countries in our normal brokerage account. A small investment here can help us sleep well at night… while also setting us up for big potential gains.
In addition to writing for American Consequences, Kim Iskyan also works with Dr. David “Doc” Eifrig on Retirement Millionaire, a monthly advisory in which Doc and Kim share investing recommendations and tips on how to retire wealthy. You can learn more about Retirement Millionaire here.