What is magnitude of risk reduction via international equity diversification

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Godzilla
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What is magnitude of risk reduction via international equity diversification

Post by Godzilla » Sun Dec 31, 2017 2:04 pm

Hi,

I have followed Vanguard's advice and for equity portion of portfolio am 60% US total stock market fund and 40% Total international stock market fund. I don't want to change the portfolio allocations - I have no clue about what the "best" ratio would be and am content to simply follow Vanguard's advice on this. But I "thnk" I feel I am less exposed to risk by having my stock assets allocated relatively close to the global weighted average. My thinking is that if I am less exposed to risk on my equity side that I can hold less in Total Bond fund. My question is: am i deluding myself feeling that I am actually significantly safer (have less overall asset value volatility) with 40% rather than 20% in international equities?

Forgive me if this has been answered before - I actually believe it has but cannot find the thread I read about it some time ago.

Thanks for help.

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Re: What is magnitude of risk reduction via international equity diversification

Post by oldcomputerguy » Sun Dec 31, 2017 2:10 pm

You might find this article from the Bogleheads Wiki useful.
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Re: What is magnitude of risk reduction via international equity diversification

Post by FIREchief » Sun Dec 31, 2017 2:13 pm

Godzilla wrote:
Sun Dec 31, 2017 2:04 pm
Forgive me if this has been answered before - I actually believe it has but cannot find the thread I read about it some time ago.
It has never been answered, and never will be. We don't know what risks the future holds, and international investing adds some risks and removes some risks. The problem is, we only know what happened in the past; not the future. 8-)
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Re: What is magnitude of risk reduction via international equity diversification

Post by simplesimon » Sun Dec 31, 2017 2:13 pm

Godzilla wrote:
Sun Dec 31, 2017 2:04 pm
My question is: am i deluding myself feeling that I am actually significantly safer (have less overall asset value volatility) with 40% rather than 20% in international equities?
Yes.

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Re: What is magnitude of risk reduction via international equity diversification

Post by tibbitts » Sun Dec 31, 2017 2:16 pm

My question is: am i deluding myself feeling that I am actually significantly safer (have less overall asset value volatility) with 40% rather than 20% in international equities?
Define significantly. Over the long term there's no way to know. Since you're wondering, why not split the difference?

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Re: What is magnitude of risk reduction via international equity diversification

Post by triceratop » Sun Dec 31, 2017 2:19 pm

tibbitts wrote:
Sun Dec 31, 2017 2:16 pm
My question is: am i deluding myself feeling that I am actually significantly safer (have less overall asset value volatility) with 40% rather than 20% in international equities?
Define significantly. Over the long term there's no way to know. Since you're wondering, why not split the difference?
I wouldn't think this way. After all the same argument applies with 0% and 30% allocation to international. So should such an investor choose 15%? My point is that these numbers are all arbitrary and so any recommendation based on splitting the difference between them is guaranteed to be flawed.
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Re: What is magnitude of risk reduction via international equity diversification

Post by jhfenton » Sun Dec 31, 2017 2:21 pm

simplesimon wrote:
Sun Dec 31, 2017 2:13 pm
Godzilla wrote:
Sun Dec 31, 2017 2:04 pm
My question is: am i deluding myself feeling that I am actually significantly safer (have less overall asset value volatility) with 40% rather than 20% in international equities?
Yes.
No. :beer

It depends on your definition of "significantly." We're actually 50% international. Is the magnitude of risk reduction huge? Probably not. Is it real and worthy of attention? Probably.

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Re: What is magnitude of risk reduction via international equity diversification

Post by ruralavalon » Sun Dec 31, 2017 2:35 pm

Godzilla wrote:
Sun Dec 31, 2017 2:04 pm
My question is: am i deluding myself feeling that I am actually significantly safer (have less overall asset value volatility) with 40% rather than 20% in international equities?
Maybe. I don't think 40% is significantly safer than 20% or 30% of stocks in international stocks.

The diversification benefit has varied at different times, and varies with the stock/bond allocation.

Historically anything over about 40% of stocks in international stocks has increased volatility rather than decreased volatility. And an international allocation at 20% of stocks has given about 85% of the diversification benefit, while 30% has given about 99% of the diversification benefit.

Please see the Vanguard paper, "Considerations for Investing in Non-U.S Equities", pp. 5-6.
Last edited by ruralavalon on Sun Dec 31, 2017 2:37 pm, edited 1 time in total.
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Re: What is magnitude of risk reduction via international equity diversification

Post by Random Walker » Sun Dec 31, 2017 2:37 pm

TSM and Int Large tend to be highly correlated. I think much better diversification of TSM portfolio by international small value. In fact I think ISV is an even better diversifier than Emerging Markets. Of course ISV is riskier than large cap growth, either US or Int.

Dave

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Re: What is magnitude of risk reduction via international equity diversification

Post by saltycaper » Sun Dec 31, 2017 2:37 pm

Godzilla wrote:
Sun Dec 31, 2017 2:04 pm

But I "thnk" I feel I am less exposed to risk by having my stock assets allocated relatively close to the global weighted average.
You are. You reduced the risks of investing in a single country and holding all your assets in a single currency; however, I myself would not change my stock/bond allocation based on this, as it is not the same thing as reducing volatility.
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Re: What is magnitude of risk reduction via international equity diversification

Post by sambb » Sun Dec 31, 2017 2:44 pm

Godzilla wrote:
Sun Dec 31, 2017 2:04 pm
My question is: am i deluding myself feeling that I am actually significantly safer (have less overall asset value volatility) with 40% rather than 20% in international equities? .

Thanks for help.
no, you are not deluding yourself

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Re: What is magnitude of risk reduction via international equity diversification

Post by jhfenton » Sun Dec 31, 2017 2:46 pm

Random Walker wrote:
Sun Dec 31, 2017 2:37 pm
TSM and Int Large tend to be highly correlated. I think much better diversification of TSM portfolio by international small value. In fact I think ISV is an even better diversifier than Emerging Markets. Of course ISV is riskier than large cap growth, either US or Int.

Dave
I agree. Our 50% international includes no international developed large cap. I dropped most of it (VTMGX/Vanguard Developed Markets Index Admiral) a couple of years ago, because it offered no apparent diversification or return advantage over VSS (Vanguard FTSE all-World ex-US Small Cap ETF). I dropped the last small piece of it when we moved our HSA in October. (VTMGX was the best fund in my employer-sponsored HSA.)

We have 30% VSS (80%/20% developed/emerging) and 20% straight emerging markets.

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Re: What is magnitude of risk reduction via international equity diversification

Post by Godzilla » Sun Dec 31, 2017 2:54 pm

OP here,

Thanks for all of the replies. Each and everyone was food for thought in different ways. I will take a couple of nights to sleep on the ideas given and discuss with my wife. Please know that your input is very valuable to me and I really appreciate it.

Wishing everyone a happy new year.

Godzilla

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Re: What is magnitude of risk reduction via international equity diversification

Post by Noobvestor » Sun Dec 31, 2017 2:59 pm

In a downturn, no stocks are safe - so that kind of safety you need to buy with bonds.

But a single national market under-performing long-term? Odds of that are pretty high - that's what you're diversifying against.

Vanguard whitepapers show a reduction in volatility anywhere between 20-60% international. I choose approximate market weights: 50%. One advance, I find, is that it doesn't really leave you questioning if you 'got it right' since you're just holding market weights.
Last edited by Noobvestor on Sun Dec 31, 2017 3:04 pm, edited 1 time in total.
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Re: What is magnitude of risk reduction via international equity diversification

Post by lack_ey » Sun Dec 31, 2017 3:03 pm

There's kind of... not enough known about stock markets, relationships between markets over time, etc. to really describe the underlying system and generate useful statistics about future risk reduction. Markets are far from independent and we can't cleanly assign known random processes with known parameters to figure out the range of possible outcomes. The risks you're reducing fall significantly into areas for which we have no data yet, and even if we did, how indicative would it really be? We're flying mostly blind.

History can give us some hints, maybe, though the markets of yesteryear don't really describe today or tomorrow's performance, and data is limited. One paper giving some perspective along these lines is International Diversification Works (Eventually) by some of the main AQR people like Asness. It shows that many country markets would have benefited from global diversification in the long run.

It's worth considering how unique the US market might be, given the large market cap, high attention paid to it globally, high liquidity, sector balance, and other features. Not every market needs as much diversification, most likely.

As such this can't be settled very rigorously and you need to make a judgment call based significantly on beliefs, assessing potential benefit vs. cost.

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Re: What is magnitude of risk reduction via international equity diversification

Post by nisiprius » Sun Dec 31, 2017 3:09 pm

Godzilla wrote:
Sun Dec 31, 2017 2:04 pm
...My question is: am i deluding myself feeling that I am actually significantly safer (have less overall asset value volatility) with 40% rather than 20% in international equities?...
This is argued endlessly. There is never a consensus answer. You need to define risk, and safety. And the answers you get are hugely dependent on what endpoints you pick, and there is no easy right way to decide which are the "right" endpoints.* From the traditional standpoint in which we accept standard deviation as a measure of risk, and the Sharpe ratio as a measure of risk-adjusted reward, yes, I think you are deluding yourself.

We can run some reasonable numbers. Portfolios 1 and 2 both represent combinations of Vanguard Total Stock Market Index Fund (VTSMX), Total International (VGTSX), and Total Bond (VBMFX). Both are 60/40 stock/bond portfolios. In portfolio 1, blue, the stock allocation itself is 80% U.S., 20% international (i.e. 48%, 12%, 40%); for red, we move to 60% U.S., 40% international (i.e. 36%, 18%, 40%). All these funds go reasonably far back. The total time period covered, May 1996 - Dec 2017, 21 years, is respectable; is far enough to include both periods when international outperformed and periods when it underperformed; and was chosen on the basis of "the entire time period over which this international stock fund has existed."

What do you think? I'm sure the actual direction of the difference is just the luck of the draw in this time period, but it's pretty noticeably that portfolio 2 actually has had just the tiniest hair higher risk as measured by standard deviation, worst year, and maximum drawdown, and lower risk-adjusted return as measured by the Sharpe and Sortino ratios. Would a different time period give different results? I'm sure it would.

The point is that if there is a risk reduction effect, it is not so strong or so robust that you have any assurance that it will actually show up, even in a 21-year-long time period... because it didn't, in this one.

Source

Image

Based on these results, I don't see any obvious reason not to go with the higher international allocation, but I think you are kidding yourself if you believe it is a powerful and reliable way to "reduce risk." Increasing bond allocation is much more powerful lever.

I also think that when people start imagining catastrophic U.S. financial collapse scenarios, they have a tendency to overestimate the likely importance of their international holding. Even if we imagine that in the middle of a systemic collapse when everything in dollars collapses. that our bank accounts and websites and Vanguard accounts keep functioning smoothly... ask yourself, how far would your present international stock holdings go in supporting you and your family?

*Which are the "right" endpoints. And what markets to include (emerging, or just developed?) And whether it's fair to go back before 1970 when the first international index starts--that is, whether to assume the Dimson and his doubtless-hard-working colleagues have assembled data that is fully reliable. And whether it's fair to include World War II... or whether it's fair to start just after World War II. And just how to deal with the two big national markets that went to zero.
Last edited by nisiprius on Sun Dec 31, 2017 3:16 pm, edited 1 time in total.
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Re: What is magnitude of risk reduction via international equity diversification

Post by Oicuryy » Sun Dec 31, 2017 3:16 pm

Portfolio Visualizer will show you the past efficient frontier.
https://www.portfoliovisualizer.com/eff ... tockMarket

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Re: What is magnitude of risk reduction via international equity diversification

Post by Svensk Anga » Sun Dec 31, 2017 5:14 pm

Oicuryy wrote:
Sun Dec 31, 2017 3:16 pm
Portfolio Visualizer will show you the past efficient frontier.
https://www.portfoliovisualizer.com/eff ... tockMarket

Ron
How 'bout that? Minimum risk occurred at about 20% foreign equity. I do believe that is the amount that Jack Bogle concedes might be okay if one must have international. Any foreign did reduce returns in the linked period however.

I am at 30% foreign and holding.

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Re: What is magnitude of risk reduction via international equity diversification

Post by johnbarry » Sun Dec 31, 2017 6:08 pm

Any recent academic studies on this? Historically exposure to international stocks added a lot of diversification, but many of the companies making up the S&P today are so exposed to the international economy that I guess the benefits of this are probably much lower than 30 years ago.
Perhaps there is some subset of international that is more worthwhile for diversification than others if I'm already holding the S&P? e.g., maybe latin america, but not so much Europe?

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Re: What is magnitude of risk reduction via international equity diversification

Post by deikel » Sun Dec 31, 2017 6:57 pm

jhfenton wrote:
Sun Dec 31, 2017 2:46 pm
Random Walker wrote:
Sun Dec 31, 2017 2:37 pm
TSM and Int Large tend to be highly correlated. I think much better diversification of TSM portfolio by international small value. In fact I think ISV is an even better diversifier than Emerging Markets. Of course ISV is riskier than large cap growth, either US or Int.

Dave
I agree. Our 50% international includes no international developed large cap. I dropped most of it (VTMGX/Vanguard Developed Markets Index Admiral) a couple of years ago, because it offered no apparent diversification or return advantage over VSS (Vanguard FTSE all-World ex-US Small Cap ETF). I dropped the last small piece of it when we moved our HSA in October. (VTMGX was the best fund in my employer-sponsored HSA.)

We have 30% VSS (80%/20% developed/emerging) and 20% straight emerging markets.

This would make no sense to me in the OP field of question. If you are tilting that heavily towards emerging market, I would argue you actually increase your risk since emerging market plays tend to be very volatile, the VSS makes sense in order to achieve diversity and maybe get some extra benefit from emerging markets - adding 20 % extra to it makes you very volatile and you should probably increase the bond allocation in order to compensate.

40% INT might not make a significant (!) difference (vs 20%), but it does help in diversification some - especially if you consider the US in a high and future stumble.
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Re: What is magnitude of risk reduction via international equity diversification

Post by BigPrince » Sun Dec 31, 2017 7:30 pm

This doesn't answer the question directly but my investment plan between US/International is to roughly mimic the proportion Vanguard Total World Stock Index Fund Investor Shares (VTWSX).

I made this decision after learning about how the Japanese economy hit ridiculously high in the late 80's and then went on a decades long slow streak down and sideways to eventually losing 80% of its value in the mid 2000's.

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Re: What is magnitude of risk reduction via international equity diversification

Post by nisiprius » Sun Dec 31, 2017 7:47 pm

John C. Bogle gave an illustration of this in his book, but I'll show one of my own. The problem with the "efficient frontier" MPT stuff is that most of the time it just puts the mask of science over performance chasing. MPT calculations based on actual past data usually just tell you to invest heavily in whatever happened to do the best over the selected time period. (In fact, if you let it, it will tell you to invest using leverage in whatever did best and short whatever did worst).

20 years is a respectably long time period. It's twice what they show you in fund literature. Here's the efficient frontier for U.S. stocks as represented by the SBBI Large Company series (S&P 500), and international stocks as represented by EAFE (oldest international index), for 1970-1989. The optimum was 82.71% international.

Image

Despite including a full ten years of overlap, slide the twenty-year period forward a decade, and the optimum shifts to 11.24% international. That's just freakin' incredible, and it should convince you to take MPT-based recommendations for international allocation with a grain of salt. 83% to 11%, for two twenty year periods, both of which have a full decade, 1980-1989, in common. And despite that anchor, what happened in the other ten years is enough to swing the optimum that far!

Image

For recent twenty-year periods, even those that include the "lost decade" for U.S. stocks, the optimum is at or close to 0% international.

Image

Of course, if you deliberately choose the "lost decade" itself, then the chart shows what we already know: during that decade, the optimum was 100% international, no U.S. I just threw that in so that I could show you a "100% international is best" chart, to balance the "0% is best" chart.

Image

What does this prove? I think it proves that these charts can't be trusted to tell you whether 20% or 40% international is better.
Last edited by nisiprius on Sun Dec 31, 2017 7:52 pm, edited 2 times in total.
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Re: What is magnitude of risk reduction via international equity diversification

Post by jhfenton » Sun Dec 31, 2017 7:49 pm

deikel wrote:
Sun Dec 31, 2017 6:57 pm
This would make no sense to me in the OP field of question. If you are tilting that heavily towards emerging market, I would argue you actually increase your risk since emerging market plays tend to be very volatile, the VSS makes sense in order to achieve diversity and maybe get some extra benefit from emerging markets - adding 20 % extra to it makes you very volatile and you should probably increase the bond allocation in order to compensate.
Agreed. Our extra EM does not reduce risk, and our 20% fixed income allocation is higher than I would otherwise have it, partly for the extra EM and partly for all the extra small cap and small cap value. (I don't want to derail the original discussion further. :beer)

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Re: What is magnitude of risk reduction via international equity diversification

Post by ruralavalon » Sun Dec 31, 2017 7:54 pm

johnbarry wrote:
Sun Dec 31, 2017 6:08 pm
Any recent academic studies on this? Historically exposure to international stocks added a lot of diversification, but many of the companies making up the S&P today are so exposed to the international economy that I guess the benefits of this are probably much lower than 30 years ago.
Perhaps there is some subset of international that is more worthwhile for diversification than others if I'm already holding the S&P? e.g., maybe latin america, but not so much Europe?
These are not "academic studies", but awhile back I had nothing useful to do and so re-read several Vanguard papers on this subject.

1) A 2008 Vanguard paper very concisely stated in its Executive Summary "Empirical and practical issues suggest a starting allocation to international stocks of 20%, with an upper limit based on the proportion of the global market they represent". "International Equity: Considerations and Recommendations" (p. 1). " . . . while mean-variance analysis suggests that an investor would have been best off in terms of lowest average volatility by allocating 40% of an equity portfolio to foreign stocks, a significant portion of the benefit can be achieved through lower allocations." (p. 5).

That paper used data through December 31, 2007.

2) A March 2012 Vanguard paper, "Considerations for investing in non-U.S. equities", stated that historically allocating 20% of an equity portfolio to non-U.S. stocks would have captured about 84% of the maximum possible diversification benefit, and allocating 30% of an equity portfolio to non-U.S. stocks would have captured about 99% of the maximum possible diversification benefit (p. 6). Their graph depicting volatility has a very flat shallow curve between 20-50%, indicating to me that it made little difference where the investor was in that range (Fig. 3, p. 5). (On a risk/return graph, the optimum location to be in is the upper left corner.)

3) A June 2012 Vanguard paper, "The role of home bias in global asset allocation decisions", has a graph describing "Risk and returns for various equity portfolios: 1988–2011" showing the better risk/return combination for a U.S. investor between 20% and 30% of stocks in international stocks (Fig 1, p. 3). The paper does say that historical performance is not the sole factor to consider (pp. 8-12).

The two 2012 Vanguard papers use data through December 31, 2011.

4) A February 2014 Vanguard paper, "Global equities: Balancing home bias and diversification", noted that U.S. equities were 49% of the global market, with a recent high of 55% of the global but remained significantly above the all-time low of 29% (p. 2, and Fig. 1, p.3). Again a graph of "Average annualized change in portfolio volatility" has a flat shallow curve between 20-50%, indicating to me that it made little difference where the investor was in that range (Fig. 3, p. 5).

From the February 2014 Vanguard paper -- "What’s striking about Figure 3 is that U.S. investors would have obtained substantial (relative) diversification benefits from allocations to non-U.S. stocks far short of the current market-proportional portfolio (now about 51% and historically approximately 50%, on average). . . . . . Looking at the blue line in Figure 3, which represents a portfolio composed entirely of equities, the maximum historical diversification benefit would have been achieved by allocating approximately 30% of an equity portfolio to non-U.S. equities (although the difference between 30% non-U.S. and 40% non-U.S. is within 0.02%), with a net reduction in volatility of 71 basis points. Allocating 20% of an equity portfolio to non-U.S. stocks would have captured 60 of those 71 basis points, or about 85% of the maximum possible benefit. " (p.6). "On average, dedicating 30% of equities to non-U.S. stocks has provided most of the maximum possible diversification benefit" (Fig. 4, p 7).

Also from the February 2014 Vanguard paper -- "Rising correlations mean less impact from global diversification" (Fig. 5, p.9). "High relative volatility means less impact from global diversification" (Fig.6, p.9).

The 2014 Vanguard paper uses data through December 31, 2013.

In 2015 Vanguard increased the interntional stock allocation in their target date funds from 30% to 40% of stocks.

I am not aware of any other or more recent Vanguard papers on the issue of the desirable amount of international stock allocation. I had thought there were more recent papers, but did not locate any.

I personally prefer the lower end of the 20-40% range, thinking there is no reason to take the extra international-related risks (like currency risk, political risk) for little or no readily apparent benefit
Last edited by ruralavalon on Sun Dec 31, 2017 8:52 pm, edited 1 time in total.
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Re: What is magnitude of risk reduction via international equity diversification

Post by sambb » Sun Dec 31, 2017 8:52 pm

One can avoid a decades long single country meltdown (like Japan) with exposure to more than one country. Just because it hasnt happened in the US yet, doesnt mean it cant. I feel like Bogle's views on international also influence objectivity herein.

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Re: What is magnitude of risk reduction via international equity diversification

Post by johnbarry » Sun Dec 31, 2017 10:13 pm

Thanks ruralavalon and nisiprius. A lot of food for thought...

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Re: What is magnitude of risk reduction via international equity diversification

Post by Jeff Albertson » Tue Jan 02, 2018 11:31 am

2017 was a good year for international diversification:
Image
https://www.bloomberg.com/view/articles ... etter-2018

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