Should you own foreign stocks?

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kolea
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Re: Should you own foreign stocks?

Postby kolea » Tue Aug 18, 2015 9:32 pm

Browser wrote:
Rick Ferri wrote:There is a portfolio benefit to re-balancing currencies to a fixed US/International allocation over time.

Rick Ferri

Any data? I've been looking for a way to separate the effects of currencies from the effects of equity returns, per se; i.e, what is the variance in returns attributable to currencies alone?


In Jeremey Siegel's book - Stocks for the Long Run, 4th Edition, he devotes a chapter to global investing. In it, he looks at exchange rate risk and how it contributes to the total risk of equities from different markets/countries. For instance...

Region, return in US dollars, domestic risk, exchange-rate (currency) risk, total risk
EAFE, 9.7%, 20.0%, 9.6%, 22.6%

He goes over several regions and different epochs (sorry, I am not going to reproduce them all here).

My takeaway from this is that (a) there is exchange rate (currency) risk for every region, and there is a lot of variation across regions, (b) it changes a lot depending on the investing epoch (time period), (c) the difference between domestic risk (i.e. what an investor in that country will see) and total risk (i.e., what we here in the US will see) varies a lot. In some cases currency risk increases the total risk by 50%.

You are definitely shouldering an additional amount of uncertainty through currency/exchange variability when you invest in foreign markets.
Kolea (pron. ko-lay-uh). Golden plover.

randomguy
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Re: Should you own foreign stocks?

Postby randomguy » Tue Aug 18, 2015 10:06 pm

Browser wrote:
As far as currency risk, odds are it will even out. Sure the US dollar could soar when I need the money. It could also plumet. I for one am not smart enough to guess how it will work out over the next 50+ years (if I am lucky) that I am investing for.

In my view, I agree with Bogle that retired income-oriented investors living in the U.S. and spending U.S. dollars for their goods and services should probably not add currency risk to the equation. Sure, it could work for you or against you but the rule of thumb is to avoid potentially significant downside risks in retirement. If currencies move against you it can take a long time for things to move the other way, while in the meantime you're taking income withdrawals and dissipating your nestegg.


I am spending us dollars. But is the price of the goods I buying set by the US dollar or by the ratio of the US dollar to the location where they are built ( china/Thailand/Germany/Mexico/Australia or a global commodity like oil)?

With only like 1/3 of the portfolio exposed to currency risks I am not losing too much sleep from the effects of currency. Ifbi had 50% of my bonds in unhedged foreign bonds, I would be a heck of a lot more motivated to look into the issue in more detail.

Browser
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Re: Should you own foreign stocks?

Postby Browser » Tue Aug 18, 2015 10:07 pm

TwoByFour wrote:
Browser wrote:
Rick Ferri wrote:There is a portfolio benefit to re-balancing currencies to a fixed US/International allocation over time.

Rick Ferri

Any data? I've been looking for a way to separate the effects of currencies from the effects of equity returns, per se; i.e, what is the variance in returns attributable to currencies alone?


In Jeremey Siegel's book - Stocks for the Long Run, 4th Edition, he devotes a chapter to global investing. In it, he looks at exchange rate risk and how it contributes to the total risk of equities from different markets/countries. For instance...

Region, return in US dollars, domestic risk, exchange-rate (currency) risk, total risk
EAFE, 9.7%, 20.0%, 9.6%, 22.6%

He goes over several regions and different epochs (sorry, I am not going to reproduce them all here).

My takeaway from this is that (a) there is exchange rate (currency) risk for every region, and there is a lot of variation across regions, (b) it changes a lot depending on the investing epoch (time period), (c) the difference between domestic risk (i.e. what an investor in that country will see) and total risk (i.e., what we here in the US will see) varies a lot. In some cases currency risk increases the total risk by 50%.

You are definitely shouldering an additional amount of uncertainty through currency/exchange variability when you invest in foreign markets.

Seems confirmed by this from WisdomTree:
Perhaps the best way to illustrate this point is to show how stocks outside the U.S. have performed over the last
three decades with—and without—currency exposure. When looking at the risk and the returns of MSCI AC World exUS
Index back to 1987, two key takeaways become evident: Foreign currency exposure added to the volatility of the
index, and foreign currency exposure served as a negative source of return compared to how the stocks performed
with no currency impact.

And here's the effect of rising correlations on volatility (it makes it even higher):
• Over the last 20 years and since the MSCI AC World exUS Index was calculated, currency risk added an incremental 2.5% volatility on top of the MSCI AC World exUS calculated in local currency terms (or with no currency risk added on top). Due to rising correlations between equity markets and the currency markets over the latest five years, this incremental contribution to risk provided by currency was twice the longterm average at 5.3% [my emphasis].

http://www.wisdomtree.com/blog/index.php/is-it-possible-to-lower-the-risk-of-international-investing-in-just-one-trade/
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Nathan Drake
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Re: Should you own foreign stocks?

Postby Nathan Drake » Tue Aug 18, 2015 10:50 pm

Returns may be similar for 30 year+ periods, but the dispersion of returns between certain periods (similar direction, but different in magnitude), makes me feel more comfortable holding foreign stocks.

Just look at the "lost decade" for US stocks after the tech-bust, international had much more robust growth. Similarly, since the 2009 recession US stocks have done a lot better than international --- international stocks are looking to have their own "lost decade".

Instead of having a depressing 10 year period for portfolio performance, a mixture of both would have been a bit easier to stomach even if you didn't reach the best highs if you timed the market better with US stocks vs. International.

There's also something to be said about certain markets getting irrational. US stocks have a much higher valuation than foreign stocks right now, and while I'm not getting rid of my domestic allocation, I feel that eventually international will recover and has much larger potential for growth right now than US stocks. I could be wrong, of course, but I feel a lot more comfortable being 50/50 US/Intl instead of 100 US which has had great returns since 2009.

Alchemist
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Re: Should you own foreign stocks?

Postby Alchemist » Tue Aug 18, 2015 11:55 pm

investorguy1 wrote:Please correct me if I am wrong but the way I see it there are risks of having all of your investments in any one country no matter how big that country is. Any of the follow situations could cause big swings in US stock prices:

1. If there is rapid inflation or deflation in the US.
2. A government default.
3. Prolonged government shut down.
4. Big changes is government policy regarding taxation, wages, trade deals etc.
5. Natural disasters.
6. War.

Bogle I don't think is worried about those potential scenarios hurting long term returns of US stocks. For those who are more worried about the short term or potential long term problems, adding foreign companies diversifying these risks.


It is actually these very reasons I hold U.S. only. If there is a massive inflation/deflation crisis in the United States, it is not just the United States that will be in trouble. ALL developed markets, due to the U.S.'s outsized influence in global currency markets, will suffer all the same. The reverse is not true. If the Euro, Yen, or Yuan tanks the effect on the U.S. dollar is transitory. In fact, any effect is likely positive not negative (flight to safety). Going the other way? Not so much. For currency, the effect of the U.S. dollar is a one way mirror. Therefore holding foreign currencies actually expose you to more black swans, not fewer. Same goes for 2 and 3. Euro government crisis? Civil unrest in Beijing? Minor, temporary effect on U.S. equities. Same issues in the U.S.? Global economic melt down. Comparing the effects of region powers, to global super powers is apples and oranges.

As for Natural disasters and war, well if the U.S. has such a massive natural disaster as to take out the economy....well the global economy is coming with us. American currency markets, banks, and our military presence around much of the world allows the current system to function. If it goes bust, there isn't anywhere to hide in equities. Same goes for war. If the South China, Korean Peninsula, or Eastern Europe sea erupts in a war foreign markets will be hit much harder than American ones. Additionally the flight to safety of American dollars, treasuries, and equities could even prove an almost anomalous "anti-fragile" effect.

Perhaps 50 years in the future, in a multi-polar world where the U.S. makes up a much smaller proportion of the world economy and the global economic/financial system the answers will be different. For now and the foreseeable horizon? I think you are exposed to more Black Swans by investing internationally than in the U.S. and this is all without referencing the demographic, regulatory, and natural resource edge the U.S. has over ALL large developed markets. Could I be wrong about those factors? Yes, but it won't matter because again if the U.S. goes down then all equities are coming with it. Reference 2008 if you don't believe me.

Then again, my view of risk is different than most. I don't see volatility as risk (unless very close to needing the money....28 year old me not so much), and a deplore anything based on back testing (even though in this case it actually supports my position).

CFM300
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Re: Should you own foreign stocks?

Postby CFM300 » Wed Aug 19, 2015 1:01 am

Taylor Larimore wrote:Bogleheads:

This is a post I made last month.

JACK BOGLE WAS RIGHT

Bogleheads:

I first read Mr. Bogle's thoughts on international investing in Bogle on Mutual Funds published in 1994. In that book he wrote:
Given the incremental currency risk, not to mention the addition of sovereign risk (the risk that a nation will default on its financial obligations and the risk of political instability or even war), your exposure to mutual funds investing in foreign stocks should not exceed 20% of your equity portfolio.

Today, I went back 21 years to see if his advice was valid. These are the results of investing $10,000 in Vanguard Total U.S. Stock Market Index Fund (VTSMX) on 7/14/1994 compared with the same investment at the same time in Vanguard Total International Index Fund (VGTSX):

VTSMX is now worth $70,756
VGTSX is now worth $24,630

I am reminded of Bill Bernstein's quote:
When I disagree with Jack Bogle – I am usually wrong.

My own stock allocation has been 20% - 30% international.

Best wishes.
Taylor

"Simplicity is the master key to financial success." -- Jack Bogle

Taylor,

You've made this post in a couple of places, and I've pointed out in each of them that Vanguard lists the inception date of VGTSX as 4/29/1996, so a comparison of the two funds beginning on 7/14/1994 is not possible.

I'll also mention that I think more evidence is needed to claim that Jack Bogle is right. Whether U.S. markets have outperformed international markets is actually irrelevant. As you know, you don't want to look at fund performances in isolation, but rather how all of the parts function as a whole. For Jack to have been right, we would need evidence that a PORTFOLIO with only U.S. stocks fared better than an equivalent PORTFOLIO that included international stocks.

randomguy
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Re: Should you own foreign stocks?

Postby randomguy » Wed Aug 19, 2015 6:49 am

Alchemist wrote:
It is actually these very reasons I hold U.S. only. If there is a massive inflation/deflation crisis in the United States, it is not just the United States that will be in trouble. ALL developed markets, due to the U.S.'s outsized influence in global currency markets, will suffer all the same. The reverse is not true. If the Euro, Yen, or Yuan tanks the effect on the U.S. dollar is transitory. In fact, any effect is likely positive not negative (flight to safety). Going the other way? Not so much. For currency, the effect of the U.S. dollar is a one way mirror. Therefore holding foreign currencies actually expose you to more black swans, not fewer. Same goes for 2 and 3. Euro government crisis? Civil unrest in Beijing? Minor, temporary effect on U.S. equities. Same issues in the U.S.? Global economic melt down. Comparing the effects of region powers, to global super powers is apples and oranges.



I don't want to debate the definition of massive but look at how international did in the 1970s compared to the US when we had massive inflation. There was no global meltdown.

As far as flights to safety, the pound was the worlds reserve currency 100 years ago. How did it perform over the next 50? Things change when you start talking about 30+ year periods and predicating what that change is is futile. I don't expect the US to collapse the same way but you never know. If the US develops a big debt crisis (figure out what the interest on our national debt would be if we had to finance it at 8%+ as a percentage of spending/GDP), I have faith the markets would struggle for a bit and then adapt. If the US adopted ruinous policies to solve the problem, it is possible that it might take it another 20 years to adapt. Odds are you will get away with taking on US only risk but it isn't a risk you are getting rewarded for. You might get lucky. You might not.

FillorKill
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Re: Should you own foreign stocks?

Postby FillorKill » Wed Aug 19, 2015 7:11 am

Browser wrote:Seems confirmed by this from WisdomTree:
Perhaps the best way to illustrate this point is to show how stocks outside the U.S. have performed over the last
three decades with—and without—currency exposure. When looking at the risk and the returns of MSCI AC World exUS
Index back to 1987, two key takeaways become evident: Foreign currency exposure added to the volatility of the
index, and foreign currency exposure served as a negative source of return compared to how the stocks performed
with no currency impact.

And here's the effect of rising correlations on volatility (it makes it even higher):
• Over the last 20 years and since the MSCI AC World exUS Index was calculated, currency risk added an incremental 2.5% volatility on top of the MSCI AC World exUS calculated in local currency terms (or with no currency risk added on top). Due to rising correlations between equity markets and the currency markets over the latest five years, this incremental contribution to risk provided by currency was twice the longterm average at 5.3% [my emphasis].

http://www.wisdomtree.com/blog/index.php/is-it-possible-to-lower-the-risk-of-international-investing-in-just-one-trade/


Browser - here's why I don't like that presentation. What they are doing is looking at the ex-US equity market when hedged versus when not from the perspective of the US investor. That's looking at the asset in isolation.

Unless, as a US investor, you have a 100% ex-US equity portfolio then this information doesn't tell you the whole story. The question should be: For a US investor holding the global equity portfolio, which includes a US dollar-denominated US equity allocation, what is the portfolio effect of hedging or not hedging the ex-US portion of the global equity portfolio? That's what matters IMO. Here are the two things you do know from the onset: 1) Hedging isn't free. 2) The diversification value of the ex-US portion of the global equity portfolio will tend to be reduced as pricing ex-US equities in dollars increases the correlation of the ex-US equity to the US equity.
Last edited by FillorKill on Wed Aug 19, 2015 7:17 am, edited 1 time in total.

indexonlyplease
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Re: Should you own foreign stocks?

Postby indexonlyplease » Wed Aug 19, 2015 7:17 am

I own the 3 fund portfolio with 20% in international. So, I guess I am playing both sides. Not investing anymore than 20% of portfolio in international. I think being in internationals had a better return so far this year. So I will go with Mr. Bogle and stay at 20% max international.


Anyway what do I know. Nothing. Just following the pros.


Clliff

Browser
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Re: Should you own foreign stocks?

Postby Browser » Wed Aug 19, 2015 9:06 am

FillorKill wrote:
Browser wrote:Seems confirmed by this from WisdomTree:
Perhaps the best way to illustrate this point is to show how stocks outside the U.S. have performed over the last
three decades with—and without—currency exposure. When looking at the risk and the returns of MSCI AC World exUS
Index back to 1987, two key takeaways become evident: Foreign currency exposure added to the volatility of the
index, and foreign currency exposure served as a negative source of return compared to how the stocks performed
with no currency impact.

And here's the effect of rising correlations on volatility (it makes it even higher):
• Over the last 20 years and since the MSCI AC World exUS Index was calculated, currency risk added an incremental 2.5% volatility on top of the MSCI AC World exUS calculated in local currency terms (or with no currency risk added on top). Due to rising correlations between equity markets and the currency markets over the latest five years, this incremental contribution to risk provided by currency was twice the longterm average at 5.3% [my emphasis].

http://www.wisdomtree.com/blog/index.php/is-it-possible-to-lower-the-risk-of-international-investing-in-just-one-trade/


Browser - here's why I don't like that presentation. What they are doing is looking at the ex-US equity market when hedged versus when not from the perspective of the US investor. That's looking at the asset in isolation.

Unless, as a US investor, you have a 100% ex-US equity portfolio then this information doesn't tell you the whole story. The question should be: For a US investor holding the global equity portfolio, which includes a US dollar-denominated US equity allocation, what is the portfolio effect of hedging or not hedging the ex-US portion of the global equity portfolio? That's what matters IMO. Here are the two things you do know from the onset: 1) Hedging isn't free. 2) The diversification value of the ex-US portion of the global equity portfolio will tend to be reduced as pricing ex-US equities in dollars increases the correlation of the ex-US equity to the US equity.

You are making an important point. I've been pondering this myself. I believe that you are correct that hedging results in a somewhat higher correlation between US equity returns and foreign equity returns vs. US equity and unhedged foreign equity. What to make of this? One can view the total returns of unhedged foreign equities (in USD) as having two components: (1) local foreign stock returns, and (2) currency, or exchange rate, returns. The variable correlation between (1) and (2) provides a portfolio "diversification effect" of sorts, compared to holding hedged foreign equities along with US equities. It would be similar to holding a "synthetic" asset made up of hedged foreign stocks + a currency ETF. Over the long run, the expected return from exchange rate movements is zero; in other words, the expected return from holding a long-only currency ETF in your portfolio is zero. So, is the "diversification effect" from unhedged vs. hedged foreign equities really useful? The mere fact that there is a lower correlation between unhedged foreign stocks vs. hedged foreign stocks with US equities might not mean very much if it is largely attributable to the influence of an "asset" with zero expected return (i.e., currency). This is similar to the debate about holding gold in one's portfolio because it improves portfolio diversification due to low or negative correlations with equities and bonds. However, since gold has a zero expected real return it can be observed that it doesn't do much for you over the long run. In the view of many, such "assets" provide diversification without much long term benefit. If this analogy holds, then it makes more sense to exclude such "pseudo diversifiers" from one's portfolio allocation because in and of themselves they have no internal rate of return.
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Re: Should you own foreign stocks?

Postby Beliavsky » Wed Aug 19, 2015 9:17 am

Browser wrote:
Beliavsky wrote:Should Canadians own only Canadian stocks? Japanese only Japanese stocks? Americans only American stocks? If your answer is "no" for them but "yes" for Americans, you need to explain why.

Well, for starters because the US stock market is much larger than any of those, the US economy is more diverse than any of those, and you can't possibly be as economically diversified if your only equity holding is in any other single country in the world. How much incremental value is added by investing outside your home country? In the case of any country in the world except the U.S. a whole lot. In the case of the U.S. maybe not so much.

I think that is an argument for U.S. investors to have less in foreign stocks than Canadian investors, but not to have zero in foreign stocks.

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Re: Should you own foreign stocks?

Postby kolea » Wed Aug 19, 2015 9:17 am

Nathan Drake wrote:There's also something to be said about certain markets getting irrational. US stocks have a much higher valuation than foreign stocks right now, ....


I find this comparison a little troubling. US equities are all required to follow the same accounting principles (GAAP, in general) as required by the SEC. What accounting methods are used in other countries? I am not saying they are bad or sloppy, but there have been many studies of how even slight changes to US accounting rules results in different numbers being reported by companies for earnings (for instance). Is it possible to even compare annual statements of companies between countries?
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Re: Should you own foreign stocks?

Postby abuss368 » Wed Aug 19, 2015 9:53 am

Excellent post Rick! We have allocated 40% of equity to international for a while and plan to stay the course.
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Re: Should you own foreign stocks?

Postby abuss368 » Wed Aug 19, 2015 9:54 am

Bogleheads,

This is the exact same argument/point Vanguard has been making in terms of international bonds.
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Re: Should you own foreign stocks?

Postby Browser » Wed Aug 19, 2015 10:31 am

So, just for the heck of it I took a look at holding: (1) 50% EFA + 50% UUP (dollar bullish currency ETF) vs. (2) 100% EFA (EAFE) from 2008 through 2013 (6 years), during which the return from currency (UUP) was essentially flat with an annualized SD of 10%. Portfolio #1 represents a synthetically dollar-hedged foreign developed equity "asset", while portfolio #2 represents an unhedged holding.

Code: Select all

Portfolio performance statistics
#   Initial Balance   Final Balance   CAGR   StdDev   Best Year   Worst Year   Max. Drawdown   Sharpe Ratio   Sortino Ratio   US Mkt Correlation
1   $10,000   $10,339    0.56%    7.55%   10.21%   -18.07%   -24.40%    0.07   0.09   0.88
2   $10,000   $10,247    0.41%    23.30%   26.95%   -41.04%   -54.42%    0.12   0.16   0.91


As you can see, the "synthetically hedged" EAFE portfolio and the unhedged EAFE portfolio produced very similar compound returns and risk adjusted returns (Sharpe ratio). However they got there in very different ways. The hedged portfolio had an annualized volatility of 7.55% and a maximum drawdown of -24.40%; while the unhedged EAFE portfolio had an annualized volatility of 23.30% and a maximum drawdown of -54.42%. Pretty crude example, but it does illustrate the beneficial effect of currency hedging during this period on the volatility of portfolio returns.

Now, when I split the portfolio 50/50 between VTI (US stocks) and either the "hedged" or "unhedged" EAFE allocation I get a similar result.

Code: Select all

Portfolio performance statistics
#   Initial Balance   Final Balance   CAGR   StdDev   Best Year   Worst Year   Max. Drawdown   Sharpe Ratio   Sortino Ratio   US Mkt Correlation
1   $10,000   $12,689    4.05%    12.76%   21.74%   -27.53%   -36.75%    0.35   0.49   0.99
2   $10,000   $12,447    3.72%    20.57%   27.92%   -39.01%   -51.33%    0.27   0.37   0.97


We have quite similar total return and Sharpe ratios, but once again the volatility of the portfolio with the "hedged" EAFE is much lower than with the unhedged EAFE (12.76% vs. 20.57%) as well as the maximum drawdown (-36.75% vs. -51.33%).

This seems to roughly illustrate that, at least over this time period, hedging foreign stocks (EAFE) produced a much smoother ride than not hedging, even though the contribution of currency returns during this period was essentially zero.

These were annually rebalanced portfolios. What about the effect of not rebalancing between VTI and EFA over this period?

2 $10,000 $12,607 3.94% 20.46% 28.28% -39.01% -51.28% 0.28 0.38 0.98

As you can see, the compound return of the "unhedged" 50/50 portfolio with no rebalancing was slightly higher with a slightly lower SD, essentially a wash. So rebalancing did not seem to extract anything extra from the currency movements during this period in which currencies produced a zero net return but had an annualized volatility of about 10%.
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Re: Should you own foreign stocks?

Postby jalbert » Thu Aug 20, 2015 1:11 am

Rick Ferri wrote:There is a portfolio benefit to re-balancing currencies to a fixed US/International allocation over time.

Rick Ferri


This is a complex issue and not at all clearcut. A retiree who rebalances into another currency when their home currency is strong is reducing the ability of their portfolio to generate income in the currency of their liabilities. But do you need to be 40% int'l to get the benefit of rebalancing? Don't I get it at 24% int'l as well?

A 40% int'l equity allocation in a taxable acct will be locked in at retirement by embedded capital gains, making it hard to dial down the currency exposure, which means you can add retiring at a time that turns out to be an unfavorable point in the secular currency cycle to the list of retirement risks. Newly minted US retirees who moved to 40% int'l equities 5 years ago, are unhappy right now, and rebalancing will just increase their currency risk.

I can't help believing that US investors should split the difference on int'l equity risks/benefits that cut both ways, and allocate int'l equities around the midpoint between zero and global market cap.

-jalbert

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Re: Should you own foreign stocks?

Postby jimkinny » Thu Aug 20, 2015 9:10 am

Rick Ferri wrote:There is a portfolio benefit to re-balancing currencies to a fixed US/International allocation over time.

Rick Ferri


Rick, thanks for posting the link to your article. Interesting to see the data available. I suppose it goes both ways: large non USA companies getting a lot of revenues from US. As I recall the decrease volatility was marginal over 30-40 years and I guess that is the diversification benefit.

Anyway, could it be the diversification benefit really may be based upon relative currency valuations?

JIm

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Re: Should you own foreign stocks?

Postby Alchemist » Thu Aug 20, 2015 3:59 pm

randomguy wrote:I don't want to debate the definition of massive but look at how international did in the 1970s compared to the US when we had massive inflation. There was no global meltdown.


Eh, massive is a relative term. And had a U.S. investor bought a balanced portfolio with stocks and bonds, and especially if they continued buying U.S. during that time they would have done quite well indeed over the long haul. If on the other hand the U.S. had Zimbabwe levels of inflation (the kind of I was thinking of with my original comment) then the global economy would have suffered quite a lot.

As far as flights to safety, the pound was the worlds reserve currency 100 years ago. How did it perform over the next 50? Things change when you start talking about 30+ year periods and predicating what that change is is futile. I don't expect the US to collapse the same way but you never know. If the US develops a big debt crisis (figure out what the interest on our national debt would be if we had to finance it at 8%+ as a percentage of spending/GDP), I have faith the markets would struggle for a bit and then adapt. If the US adopted ruinous policies to solve the problem, it is possible that it might take it another 20 years to adapt. Odds are you will get away with taking on US only risk but it isn't a risk you are getting rewarded for. You might get lucky. You might not.


Britain's previous role is not analogous to the current U.S. role. Back then it was a multi-polar world and Britain was not an undisputed superpower but rather one of many great powers (France, Germany, Russia, Ottoman Empire, etc).

My main point is NOT that the U.S. is invincible. Rather, it is that the U.S. is more robust than the rest of the world and that anything big enough to take out the U.S. economy will bring down everyone else anyway. Just as important, is that the reverse is not true. If the current worst case suspicions about the state of China's economy are accurate, then Europe, Japan, and South Korea will suffer a lot more than the U.S. will.


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