Vanguard and others have put a lot of emphasis on bonds diversification using international bonds in recent years, while the Bogleheads community mostly shrugged. This article studies the effect of such diversification through backtesting techniques, looking at both regular International bonds and Emerging Market bonds. We’ll take a close look by studying monthly returns to better analyze the volatility and correlation properties of various portfolios. Then we’ll perform a similar study about diversification of equities with domestic, global or international real estate funds.
This article is the third part of a study looking at global and domestic investing from the perspective of local investors.
In Part 1 and Part 2, we took the position of a local investor in one of 16 countries of interest, and we explored somewhat extreme positions of either investing 100% global or 100% domestic. It is now time to try a more balanced view of things, and study portfolios mixing global and domestic investments. We will notably look at the mitigation this could bring to the countries having fared the worst, but also consequences for countries having fared better. Of course, it is easy to look at such numbers in hindsight and draw hasty conclusions, so let’s keep in mind that nobody could have predicted winners and losers ahead of time.
Many North American investors tend to look carefully at historical returns in the US and in Canada, and draw various conclusions. Occasionally, some references are made to Japan and the UK, and few people look any further. The world changes though. The UK was undoubtedly the world economic leader at the end of the 19th Century, while the US clearly dominates nowadays. Japan was on a roll, had a bigger market capitalization than the US in the 80s, and yet badly faltered since then. The world changes in ways we cannot predict, and it would be naive to assume that several decades from now, the situation will be similar to today’s environment. One thing we can do to get some perspective, is to try to draw some analogies with what happened in a larger sample of countries.
This article focuses on the historical returns from 16 developed countries, looking from the perspective of a local investor, and assuming a strong home country bias to begin with (i.e. solely using domestic stocks and domestic bonds). We will look at more diversified portfolios mixing domestic and global investments in Part 3.
True Bogleheads know the power of diversification. And yet, many such investors (including John Bogle himself!) are reluctant to diversify beyond domestic investments. Japanese investors could have perceived the same thing, with a remarkable run in the 80s in terms of market capitalization (nearly half of the world, higher than the US at some point) and in terms of stock returns. Unfortunately for Japan, as discussed in a previous blog article, this impressive success was followed by the worst equity crisis in modern history. This study about Japan also showed how some level of international diversification would have helped a local investor to mitigate this extremely painful crisis.
This raised an interesting question. Could one simply invest in the world, using global stocks and global bonds? And if this proves unsatisfying, is there a proper middle ground between domestic and global allocations?
This article is a follow-up to the “short study of the recent Japanese crisis” which was published on this blog a few days ago. The study was actively discussed on the Bogleheads forum. Various interesting questions were raised that weren’t directly addressed by the original write-up, and triggered the author to do more research about domestic tilts (or lack thereof), variable withdrawals, and past performance of the stock market in Japan.
Based on public data sources providing Japanese stock returns and bond interest rates, this article provides a quantitative analysis of the trajectory a Japanese passive investor could have experienced with his portfolio during the 1980-2016 time period. Japan suffered from what was probably the most severe stock crisis in modern history, starting by the end of 1989, taking nearly two decades to finally somewhat recover, and then being slammed again by the financial crisis of 2008. There is no equivalent in U.S. history of such long lasting crisis, and as such, it is a sobering example of what could happen.
Introduction As many Bogleheads know, we maintain a backtesting spreadsheet dubbed ‘Simba’ (after the original author of the work), allowing us to compare one or several portfolios against historical data. This spreadsheet provides data series representing major asset classes, using historical …
A major revision to the Simba spreadsheet Read More »
Ever since the 1957 publication of James Tobin’s seminal paper on what has become known as “The Separation Theorem” (Liquidity Preference as Behavior Towards Risk for those intrepid souls willing to sample it) , investors have had the theoretical basis …
Tobin’s Separation Theorem : the dilution of risk Read More »
Individual investors rarely employ sophisticated asset allocation methodologies, such as mean variance optimization, monte-carlo simulation, or probabilistic scenario analysis in formulating and implementing investment policy. Instead, they often employ “naive” strategies, such as equally dividing the pallet of asset classes.