Home Bias – Autumn 2010
Recently, a client asked me this question: “How do you decide how much of my account to put into foreign stocks?” As usual, a short question results in a longwinded answer. Here goes:
Equities can be classified as belonging to the: 1) Domestic Market, 2) International Market, and 3) Emerging Market. We find it useful to classify them this way because the three markets have differentiating characteristics. First, we can define the markets in this way:
United States of America
United Kingdom, Ireland, Canada
Australia, New Zealand
France, Germany, Switzerland, Austria
Spain, Italy, Portugal, Greece
Netherlands, Belgium, Denmark
Sweden, Norway, Finland
Hong Kong, Singapore
China, Taiwan, South Korea
Brazil, Chile, Mexico
Russia, Poland, Czech Republic, Hungary, Turkey
Thailand, Malaysia, Indonesia, Philippines
According to Dimensional Fund Advisors (DFA), as of year end 2009 the domestic market makes up 42% of the entire world by capitalization, the international market makes up 44%, and the emerging market makes up 13%. (For you math whizzes, there is another 1% of market capitalization that resides in countries that we consider too risky and expensive to invest in.
Since it is not possible to predict which of the three markets will perform the best, and since we believe that diversification increases safety without an expected loss of return, it would seem logical to simply weight our accounts 42% US, 44% International, and 14% Emerging.
A review of a typical account will show that in fact we have more invested domestically than 42%, and less in the international and emerging markets. Why is this?
We have an intentional “home bias” toward US securities. This comes about for the following reasons:
International Securities are more expensive
It is more expensive to invest in international securities, and more expensive yet to invest in emerging markets. These higher costs can be observed by examining the published expenses of international investments verses domestic investments.
International Securities are riskier
International securities demonstrate increased volatility due to fluctuations in the various currencies in which they are denominated. Secondly, “political” risk is greater in international and emerging markets. Political risk is the risk of dysfunctional markets due to unstable governments and governments hostile to free markets.
Because of our home bias, a typical account at Financial Plan, Inc has a weighting of 65% Domestic, 25% International, and 10% Emerging Market Securities.
If you have any questions or would like more detail on this topic, Jamie and David are available during business hours, and Devin is available 24 hours a day, 7 days a week. 🙂