Is Home Bias necessarily bad?

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Eferv
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Is Home Bias necessarily bad?

Post by Eferv » Wed Dec 21, 2011 5:55 pm

Hi,

I haven't made my allocation decisions yet but I'm loosely modeling the Swenson Portfolio, which allocates 30% to US stocks, and then only 15% and 10% to Foreign Developed & Emerging Markets.

This looks like a home bias. Question is, is that bad? Swenson mentions that US stocks have the best risk-adjusted return and Emerging Markets the worst. Considering this, it makes sense to me that US gets a larger allocation, but maybe I'm thinking about this incorrectly.

Thanks

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Re: Is Home Bias necessarily bad?

Post by bottlecap » Wed Dec 21, 2011 6:25 pm

I think the biggest risk you face if you don't have a home bias is currency risk, since you will be spending your home country dollars in retirement (unless you've done really, really well :wink: ), but perhaps someone else can confirm this?

JT

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Re: Is Home Bias necessarily bad?

Post by bertilak » Wed Dec 21, 2011 6:43 pm

bottlecap wrote:I think the biggest risk you face if you don't have a home bias is currency risk, since you will be spending your home country dollars in retirement (unless you've done really, really well :wink: ), but perhaps someone else can confirm this?

JT
Well, I don't have the authority to confirm anything, but it makes sense to me and I allocate my equities 70/30 US/International.
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Re: Is Home Bias necessarily bad?

Post by ilmartello » Wed Dec 21, 2011 7:06 pm

bottlecap wrote:I think the biggest risk you face if you don't have a home bias is currency risk, since you will be spending your home country dollars in retirement (unless you've done really, really well :wink: ), but perhaps someone else can confirm this?

JT
A lot of goods people purchase now are imported, so I don't understand the logic on this.

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Re: Is Home Bias necessarily bad?

Post by nisiprius » Wed Dec 21, 2011 7:17 pm

I object to the idea that holding a lower-than-global-cap-weighting of international stocks is necessarily home bias.

If there were a single world currency then I would cap-weight globally. But if there were a single world currency then I would expect charts like this to show the maximum diversification effect at 55-60% international.
Image
I'm pretty sure that the reason the charts don't come out this way is because of currency risk. Without currency risk, foreign stocks would have similar characteristics to U.S. stocks but would be somewhat uncorrelated. That would lead to the optimum weighting being global cap-weighting. But foreign stocks do have currency risk, which is added on on top of their intrinsic stock market risk. (This, by the way, is explicit in the Prospectus for any international stock fund. In the "principal risks" section, the international fund will show "stock market risk" and "currency risk.") As you increase your percentage of international stocks from zero to global cap-weight, you have a balancing act. Diversification increases, causing the total portfolio volatility to decrease, but currency risk also increases, causing portfolio volatility to increase. I believe what the Fidelity chart is showing us is that there is a very broad, very shallow optimum--and it is not at global cap-weighting, it is at something like 25%-50%.

I find it difficult to dialog with the posters who simply engage in "proof by repeated assertion" to show that one should use global cap-weighting. They usually say "if you don't know what region will do best, if you are neutral in your assumptions about the future, you should buy them all, cap-weighted." My response to that is if you don't know the future direction of U.S. currency--if you are neutral in your assumptions about currency movement--you should use the sort of allocations recommended by Vanguard and which they themselves us in their target-date funds: 20%, 30%, 40%, something in that range.

There is an implicit assumption among some posters that the U. S. dollar is certain to weaken farther. There is also, I think, a subtext is that the U. S. is going to crash and that foreign investments can be a parachute. But in a true crisis situation, the U.S. might impose currency exchange controls as governments are wont to do in such situations.

For any number from 0% to cap-weighted (55-60%) you can easily find some authentic expert to endorse it. So why not just pick what appeals to you, call it good, and stick with it?
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Re: Is Home Bias necessarily bad?

Post by ruralavalon » Wed Dec 21, 2011 7:32 pm

"Is Home Bias necessarily bad?" In my opinion, no.

Here is my favorite resource on this issue -- https://institutional.vanguard.com/iam/ ... lbrief.pdf -- a source I respect, and a paper which is readable.
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Re: Is Home Bias necessarily bad?

Post by ilmartello » Wed Dec 21, 2011 7:44 pm

There is no doubt recency effect in the sense that between 1990-2000, the us stock market did particularly well, east asian tigers went down, russia had a crisis, etc. and Now after the us market had poor returns, people are looking to give more weight to international.

My problem with the home bias advocates is the idea you will be spending US dollars in retirement. A lot of our goods, think electronics, some food products, raw materials, are imported and will be affected by currency fluctuations, regardless of whether or not you use USD at the point of sale.

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Re: Is Home Bias necessarily bad?

Post by nisiprius » Wed Dec 21, 2011 8:16 pm

ilmartello wrote:My problem with the home bias advocates is the idea you will be spending US dollars in retirement. A lot of our goods, think electronics, some food products, raw materials, are imported and will be affected by currency fluctuations, regardless of whether or not you use USD at the point of sale.
Image
Mr. Strawman: What's the U. S. dollar been doing? Weakening, that's what it's been doing! Down, down, down it goes, steadily and inexorably. And because the U. S. dollar is absolutely certain to weaken farther, you will be paying more for imported goods. Why, look at how much your cost of living increased since 2002.

Me: Well, actually it didn't increase all that much. Inflation was pretty tame during that time period.

Mr. Strawman: Yes, but it should have! And, mark my words, it will.

Me: Yeah, so my cost of living will increase. I'm worried about that. That's why I have a reasonably high percentage of my portfolio in assets that are directly indexed to the CPI, and a modest SPIA that's indexed to the CPI. And of course my Social Security is indexed to the CPI.

Mr. Strawman: No, no, no, don't do that! You should not try to deal with the cost of living by using things that are indexed to the CPI. That is unworthy of a serious investor. Be a real investor. Invest like a man. Invest in other things. Invest in things that are supposed to keep up with inflation, in the long run. Sorta-kinda. While giving you thrilling ascents and chilling plunges in the short run. Why, look at real estate, for example. They aren't making any more land, y'know! Look how well a real estate investment in Amsterdam did. Doubled in real value in just four short centuries. Oh, some volatility here and there--but wow, an annualized return of 0.2% real!
Image
Wouldn't you rather have that then your wimpy old TIPS, that will never give you the potential of doubling your money in a short time--and halving it in a shorter time? Gold! Foreign currencies like the Swiss franc, the soundest currency in the universe even if they did just devalue it. Commodities! That's what you should be investing in.

Me: Uh, why shouldn't I just use CPI-indexed assets?

Mr. Strawman: Because I can't make any money out of selling TIPS, for gosh sa--I mean, because the CPI is cooked. You can't trust it. It underestimates inflation.

Me: Well, when you say your favorite inflation-hedging investments have thus-and-such return, what do you use to measure them? That same cooked CPI?

Mr. Strawman: Oh, my goodness, you have me there. I give up. You, sir, have won the argument, fair and square. I shall order me some Series I savings bonds today.

(In my dreams...) :)
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Re: Is Home Bias necessarily bad?

Post by ilmartello » Thu Dec 22, 2011 1:30 am

Let me just poke some holes into the dollar index because I am a meanie like that.

I don't think it's a good metric because it's kind of arbitrary in how it determines what currencies are included in the dollar index. If I are we you should look at the trade -weighted dollar index which includes a broader basket of currencies. :D
http://en.wikipedia.org/wiki/Trade_Weig ... llar_Index

I don't think that keeping the market weight in equities is being pessimistic or optimistic on the us econom or us currency in fact, I think it's being very neutral. If you look at one of the most prominent activists of a home bias, named Jack Bogle, you may have heard of him :D , I remember one time he advised for a US tilt because he was pessimistic of W. Europe and Japan, and thought emerging markets were overbought. If I was advocating for a us weight of lower than world capitalization, you could make that argument that I was pessimistic.

Oh, and re: your real estate example, just to nitpick, if you wanted to look at real estate as an investment you should look at rents plus the price change. Good link finding historical rent data for the last 400 years.

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Re: Is Home Bias necessarily bad?

Post by nisiprius » Thu Dec 22, 2011 6:34 am

ilmartello wrote:Let me just poke some holes into the dollar index because I am a meanie like that.

I don't think it's a good metric because it's kind of arbitrary in how it determines what currencies are included in the dollar index. If I are we you should look at the trade -weighted dollar index which includes a broader basket of currencies. :D
http://en.wikipedia.org/wiki/Trade_Weig ... llar_Index
Cool. I (actually) learned something. Can you point me to a suitable historical chart of that index?

I'll Google...

Here's one. Not terribly different from the dollar index to this eye. It's from a website whose point is dollar crashes to record low, but it is still true that 2002-2008 was far more significant than anything that has happened since... and that the difference between the strengthening form 1995-2002 and the weakening from 2002-present did not result in any grossly-obvious-to-the-consumer changes in the cost of living.
Image
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Re: Is Home Bias necessarily bad?

Post by Trev H » Thu Dec 22, 2011 7:39 am

Eferv,

So where do you call "home" ? Bermuda, Peru, Chile ?

If you did live in one of those EM countries, would it be OK to lump the large majority of your investments (say 80-50%) into domestic assets ?

Why ? because you feel better about your home country ? something you are familliar with ? have faith in ?

Home country bias is just as foolish for someone that lives in the US as it would be for someone that lives in Peru and for the same reasons.

Bottom line is it leads the investor into a lack of diversification.

Any country is subject to serious mis-fortune at some point in time.

"Divide your portion to seven or even to eight, for you do not know what mis-fortune may occur on the earth". Ecclesiastes 11:2

Trev H

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Re: Is Home Bias necessarily bad?

Post by jimkinny » Thu Dec 22, 2011 8:04 am

From what i have read, home bias may enhance returns or detract from returns, depending upon your time frame and where home is located or it may not matter much at all.

I would hate to have 40% of my portfolio invested in Greece right now, but maybe the next 40 years will show that Greece has outperformed the rest of the world.

Nisiprius has influenced my thinking about this a lot. Having some home bias doesn't seem to matter much historically, over long periods of time, for a US investor. Of course, this may change in future, but we got to have some data to based decisions upon.

Savings probably matters a whole lot more than the difference in a 20% vs 50% international allocation over the long term.

See Groks tip number 11 for his take on having bonds vs stocks and the importance of that decision and I really like his suggestion to have "some" international allocation.

And of course, what I remember from reading/listening to John Bogle is that he is not much of a fan of market cap weighting international equity in one's portfolio.

Jim

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Re: Is Home Bias necessarily bad?

Post by bottlecap » Thu Dec 22, 2011 9:10 am

ilmartello wrote:
bottlecap wrote:I think the biggest risk you face if you don't have a home bias is currency risk, since you will be spending your home country dollars in retirement (unless you've done really, really well :wink: ), but perhaps someone else can confirm this?

JT
A lot of goods people purchase now are imported, so I don't understand the logic on this.
You may be right to some extent, but if you think about it, most things we actually spend money on are not imported - goods and services you have to buy in your home country. Moreover, where goods are produced are not set in stone and where goods come from will change with major currency fluctuations. If Indonesia's currency makes clothes too expensive from them to produce to sell in your home country, some other country's industry will begin making clothes for export to your home country. This is a built-in protection that doesn't require overexposure to a particular country and doesn't require you to try to guess which country you'll need to invest in.

JT

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Re: Is Home Bias necessarily bad?

Post by larryswedroe » Thu Dec 22, 2011 9:52 am

Home country bias is VERY BAD, one of worst---caused by confusing the familiar with the safe, and leads to not only US overinvesting, but overinvesting in stocks we know because we live near them--diversification is the only free lunch so you might as well eat as much of it as possible

Now you might get lucky if your country does well, but you might be the next Japan. Don't judge strategy by outcome, but by what alternative universes might have shown up. The failure to do so can make you think your are a genius when you were simply the beneficiary of a good roll of the dice.

This mistake is just one of the 77 covered in my new book, Investment Mistakes Even Smart Investors Make

Best wishes
Larry

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Re: Is Home Bias necessarily bad?

Post by maxfax » Thu Dec 22, 2011 11:48 am

IMO you get the answer to the question by asking why the different advice-givers have an agenda behind their advice.
* The people advocating passive investing want to have some 'rule' for allocations off-shore. The existence of 'rules' makes it appear that no subjective decision is being made. What better rule than world-wide market cap? But the rule is just an arbitrary decision like any other investing decision. It is an essentially subjective decision which 'rules' you decide to live by.
* The people issuing funds know that your unfamiliarity with the foreign companies will make it more likely that you use a fund rather than stock-pick. They want you to buy their funds so they promote foreign investing.
* The academics promoting foreign investing want to keep people referencing their work and providing themselves with a job-for-life. So they purposefully mis-measure currency risk (in order to falsely conclude it does not matter and even adds value). [link removed by Mod]

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Re: Is Home Bias necessarily bad?

Post by larryswedroe » Thu Dec 22, 2011 11:58 am

Maxfax
Disagree very much with your statements. My advice is based on SCIENCE, peer reviewed research that shows that because of home bias (which is nothing more than confusing something that is familiar with something that is safe) leads to inefficient portfolios, overconcentration. It cannot be right that for example US investors tend to have 80-90% invested domestically because they believe US is safest and has the highest expected returns. Obviously those statements together cannot be right as risk and expected return are related. Also the same is true of virtually any where in the world you look, studies find the same home biases for the same reasons. And investors overconcentrate in local stocks. It cannot be that investing in Coca Cola is safer because you live in Atlanta than if you live in Houston, or Enron is safer if you live in Houston. In fact it can be more risky because of how a company's failure can impact the local economy and home values, etc.

Best wishes
Larry

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Re: Is Home Bias necessarily bad?

Post by bertilak » Thu Dec 22, 2011 12:10 pm

larryswedroe wrote:Maxfax
Disagree very much with your statements. My advice is based on SCIENCE, peer reviewed research that shows that because of home bias (which is nothing more than confusing something that is familiar with something that is safe) leads to inefficient portfolios, overconcentration. It cannot be right that for example US investors tend to have 80-90% invested domestically because they believe US is safest and has the highest expected returns. Obviously those statements together cannot be right as risk and expected return are related. Also the same is true of virtually any where in the world you look, studies find the same home biases for the same reasons. And investors overconcentrate in local stocks. It cannot be that investing in Coca Cola is safer because you live in Atlanta than if you live in Houston, or Enron is safer if you live in Houston. In fact it can be more risky because of how a company's failure can impact the local economy and home values, etc.

Best wishes
Larry
Larry,

Isn't "currency risk" a risk factor that would depend on what currency you expect to spend your money in? And wouldn't that mean that people in different "currency environments" (to coin a term) might see different risks and therefore have different allocations? And wouldn't favoring assets priced in the local currency be reducing the risk, and doing so (I haven't thought this part through) without (proportionally?) reducing expected return?
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Re: Is Home Bias necessarily bad?

Post by ilmartello » Thu Dec 22, 2011 12:48 pm

Isn't currency fluctuation supposed to have an expected return of 0

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Re: Is Home Bias necessarily bad?

Post by nisiprius » Thu Dec 22, 2011 2:05 pm

ilmartello wrote:Isn't currency fluctuation supposed to have an expected return of 0
Yes, but it adds risk. That is not neutral. That is equivalent to lowering return. Adding risk without adding commensurate return is bad.

If you invest in something riskier, but you do not wish to add risk to the portfolio, then you must invest in less of it, so you will get less return.

On the other hand diversification is good. If the riskier asset you're choosing is that if it is poorly correlated with other assets, you still need to cut back on it in order to keep portfolio risk constant, but you don't need to cut back on it in proportion to its increased risk.

It is a balancing act. International stocks diversify a portfolio, reducing risk. They also add currency risk to a portfolio, increasing risk. The balance point is not at cap-weighted allocation. The Fidelity chart I showed you above does not have its optimum at a cap-weighted allocation. It has an optimum at a lower than cap-weighted allocation. If currency risk doesn't matter, if international investing is a free lunch diversification, why doesn't that chart show the minimum risk at 55%?
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Re: Is Home Bias necessarily bad?

Post by DartThrower » Thu Dec 22, 2011 2:12 pm

I have seen and read Mr Bogle address this issue on many occasions.

My take is that he is concerned with the recent popularity of foreign stocks and that such popularity will lead to disappointment eventually among less experienced investors, if and when international stocks cool off. I believe he is also concerned that foreign countries may not have embraced capitalism and equity markets with the same level of long term conviction that America has. Other countries may or may not have the culture conducive to equities that we have. If this is true, is it really diversification?

I cite these considerations in addition to those already mentioned (we buy things in dollars, not yen... etc etc). Keep in mind that Mr Bogle speaks to all investors - even inexperienced ones. He may have been of the belief that people would potentially misinterpret his embrace of international investing at a time when increased international allocation was extremely popular to do. This could lead to more of the speculation that he dreads so much.

His stance against overdoing international investing seems to have softened somewhat recently as the evidence coming in has been pretty persuasive in favor of 20-40% international equity as a percent of total equity. I just don't think he thinks that going over 20% will matter that much anyway for the reasons already mentioned.

For what it's worth, my portfolio is at about 30% international as a percent of total equity. I am therefore 10% north of what he thinks is the high end of the range, but I doubt he would care since I follow his advice in other areas.
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Re: Is Home Bias necessarily bad?

Post by bottlecap » Thu Dec 22, 2011 2:13 pm

ilmartello wrote:Isn't currency fluctuation supposed to have an expected return of 0
Which currency? You could also argue the same for an investment like gold. Expected return does not always equal actual return and is no guarantee, and is especially dependent on when you need to cash out. The expected return of stocks may be 8% per annum, but if you hold 100% for thirty years and retire during a crash, your 8% just flew out the window.

JT

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Re: Is Home Bias necessarily bad?

Post by larryswedroe » Thu Dec 22, 2011 2:54 pm

bertilak
Currency risk is TWO way, not one way street
It is home bias that causes people to think otherwise
Best
Larry

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Re: Is Home Bias necessarily bad?

Post by maxfax » Thu Dec 22, 2011 3:06 pm

ilmartello wrote:Isn't currency fluctuation supposed to have an expected return of 0
That is the misleading conclusion the academics support. But they got there with bad math. [link removed by Mod]

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Re: Is Home Bias necessarily bad?

Post by nisiprius » Thu Dec 22, 2011 3:52 pm

larryswedroe wrote:bertilak
Currency risk is TWO way, not one way street
It is home bias that causes people to think otherwise
Best
Larry
Larry, all risk is a "two-way street." But added risk without commensurate added return is bad, and that is not a two-way street.

In the case of international stocks, it is a balance between the beneficial effect of diversification and the harmful effect of extra risk without extra return. If there were no currency risk, then international investing would be more beneficial than it is, and the balance point should be struck at a higher international allocation than in the presence of currency risk.
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Re: Is Home Bias necessarily bad?

Post by Leif » Thu Dec 22, 2011 3:54 pm

I don't know. You may try asking the Japanese.

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Re: Is Home Bias necessarily bad?

Post by larryswedroe » Thu Dec 22, 2011 5:18 pm

Nisprius
If you hedge currency risk in international equities you INCREASE the correlation of returns, reducing the diversification benefits
Larry

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Re: Is Home Bias necessarily bad?

Post by nisiprius » Thu Dec 22, 2011 7:30 pm

larryswedroe wrote:Nisprius
If you hedge currency risk in international equities you INCREASE the correlation of returns, reducing the diversification benefits
Larry
Larry: is this chart inaccurate? It is from a 2009 Fidelity publication, Why Foreign Stocks Are Important
Image
Fidelity concluded: "We believe devoting 30% of your overall stock exposure to international makes the most sense. This level provided nearly all (94%) of the diversification benefits that a 40% international allocation did, with a lower chance of increasing risk over shorter time periods."

Vanguard has a paper that displays an almost identical chart and comes to very similar conclusions.

If the chart is correct, going from 30-40% international to (cap-weighted) 50-60% increases volatility.
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Re: Is Home Bias necessarily bad?

Post by Eferv » Thu Dec 22, 2011 7:56 pm

^^I sure hope that chart is right. My current plan is

35% US
20% Developed
10% Emerging Markets

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Re: Is Home Bias necessarily bad?

Post by larryswedroe » Thu Dec 22, 2011 8:29 pm

Nisprius
Data like that is data mining, all efficient frontier models are backward looking and can give nonsensical answers as I have shown in my books

But historically, if memory serves the sweet spot has been around 40%.

But to show why that is silly, just ask a Japanese investor what the sweet spot it and see what answer you get. Especially if you take the last 22 years as your history.

IMO the right starting place is world cap weighting, then add small home country bias to account for higher costs of international funds and lower tax efficiency, so say 50% international instead of almost 60%. And 40% is better than 30 and 30 is better than 20.

I hope that is helpful

Best wishes

Larry

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Re: Is Home Bias necessarily bad?

Post by patrick » Thu Dec 22, 2011 8:45 pm

nisiprius wrote: Without currency risk, foreign stocks would have similar characteristics to U.S. stocks but would be somewhat uncorrelated. That would lead to the optimum weighting being global cap-weighting. But foreign stocks do have currency risk, which is added on on top of their intrinsic stock market risk. (This, by the way, is explicit in the Prospectus for any international stock fund. In the "principal risks" section, the international fund will show "stock market risk" and "currency risk.") As you increase your percentage of international stocks from zero to global cap-weight, you have a balancing act. Diversification increases, causing the total portfolio volatility to decrease, but currency risk also increases, causing portfolio volatility to increase. I believe what the Fidelity chart is showing us is that there is a very broad, very shallow optimum--and it is not at global cap-weighting, it is at something like 25%-50%.
I will note that the referenced chart only covers a 40 year period, and only includes EAFE for foreign stocks. To make conclusive judgments about the interaction between different assets I would want to more.

I agree with you that currency risk is a plausible reason to deviate from the global market weight. But it's not the only imaginable one -- assuming that we can't make any predictions about currencies, these also worth considering:

1) Governments might give domestic investors an advantage over foreign investors, so the expected return of stocks is slightly lower for foreign investors than domestic ones. For example, if the Thirteenth National Bank of Nowheristan goes bankrupt, the government of Nowheristan might decide to bail out citizens of Nowheristan who invested in the bank, but at the same time leave investors from outside Nowheristan without compensation.

2) Investment fees vary by country. For a US investor this is another reason to tilt toward home, though for a foreign investor using US-based ETFs it's a reason to tilt away from home. However, with Vanguard ETFs it's now only 0.22% even for emerging markets so this doesn't seem compelling to me.

3) Avoiding single-country risk. Most of us would agree that 40% or more in Indonesian stocks is too much single-country risk, so why not apply the same rule to US stocks?

4) Factoring in your earning power, or pension if retired). These are tied to your home country, so you are heavily "invested" in your home country exposure even before any home country stocks at all are involved. For someone early in their career, the loss in earnings from a prolonged economic downturn is likely to cause a greater loss than even a 100% fall in the stock market.

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Re: Is Home Bias necessarily bad?

Post by dyangu » Thu Dec 22, 2011 8:51 pm

larryswedroe wrote: My advice is based on SCIENCE, peer reviewed research that shows ...
I'm sorry but macro economics is not a science. In science, we come up with a hypothesis based on logic and past experience and then test it in a double blind trial with a control group. In economics and investing research, we come up with a hypothesis based on logic and past experience. That's it. There are no controlled trials to validate a hypothesis.

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Re: Is Home Bias necessarily bad?

Post by yessiree83 » Thu Dec 22, 2011 9:52 pm

nisiprius wrote:
ilmartello wrote:Isn't currency fluctuation supposed to have an expected return of 0
Yes, but it adds risk. That is not neutral. That is equivalent to lowering return. Adding risk without adding commensurate return is bad.
If that were true then the best course of action would not be to avoid alternative currencies, but to rebalance the heck out of them and retire early on the diversification return. But Bogleheads don't believe such free lunches exist, which implies Bogleheads don't believe volatility/risk exists without commensurate return.
nisiprius wrote: why doesn't that chart show the minimum risk at 55%?
Because the unit of measure they used is wrong:
According to the method used, greenbacks stuffed under the mattress have zero volatility, but greenbacks don't really have zero volatility because their spending power fluctuates. So all the volatility/risk measurements are skewed and to correct it you need to multiply the overall portfolio value by either a portfolio of TIPS or, if you believe the books are cooked, the value of a trade weighted basket of currencies.

Once you make that correction, the minimum risk should be closer to 55%
Last edited by yessiree83 on Thu Dec 22, 2011 9:54 pm, edited 1 time in total.

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Re: Is Home Bias necessarily bad?

Post by nisiprius » Thu Dec 22, 2011 9:53 pm

larryswedroe wrote:Data like that is data mining, all efficient frontier models are backward looking and can give nonsensical answers as I have shown in my books
patrick wrote:I will note that the referenced chart only covers a 40 year period, and only includes EAFE for foreign stocks. To make conclusive judgments about the interaction between different assets I would want to know more.
So would I, but
  • it is basically "all available data" which I don't think is fair to call "data mining;"
  • it is exactly the same amount of data that Larry Swedroe uses to illustrate "the power of Modern Portfolio Theory" on pp. 135-140 of The Quest for Alpha;
  • it is the same index, MSCI EAFE, that he uses to represent "an exposure to international equities" in his example.
yessiree83 wrote:Because the unit of measure they used is wrong:
According to the method used, greenbacks stuffed under the mattress have zero volatility, but greenbacks don't really have zero volatility because their spending power fluctuates. So all the volatility/risk measurements are skewed and to correct it you need to multiply the overall portfolio value by either a portfolio of TIPS or, if you believe the books are cooked, the value of a trade weighted basket of currencies.

Once you make that correction, the minimum risk should be closer to 55%
This is a good point. Although I don't know how to check it out. Despite theory, though, the dollar index and/or the trade-weighted dollar index do not seem to have much correlation with inflation, so I'm not so sure as to how it would actually work out.
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Re: Is Home Bias necessarily bad?

Post by yessiree83 » Thu Dec 22, 2011 10:26 pm

nisiprius wrote:This is a good point. Although I don't know how to check it out. Despite theory, though, the dollar index and/or the trade-weighted dollar index do not seem to have much correlation with inflation, so I'm not so sure as to how it would actually work out.
Then toss in some gold and commodities (coincidentally also maligned with accusations of "zero return")...or if that makes your head explode and you're more comfy with US sovereign risk, TIPS.

My policy is only to invest in what I understand and I understand a bit about the cap weighted portfolio of all investable assets. However, once you start removing cards from the deck I don't understand the game too well anymore (even though it's easier to measure/count them) and wacky things seem to happen. All I can say is I don't think it's a coincidence that commonly disparaged (but well capitalized) asset classes seem to rally at the same time as well lauded portfolios that don't make sense (and are undercapitalized) such as slice & dice.

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Re: Is Home Bias necessarily bad?

Post by stlutz » Thu Dec 22, 2011 11:14 pm

Threads like this are dangerous. They lead to allocation tinkering and trend chasing. After all, who would want to have a "biased" or "unscientific" international allocation? Or worse yet, be off the "efficient frontier!"

Nobody knows ahead of time what percentage mix will work the best over the next 20 years. Picking a percentage and sticking with it is the correct answer; changing your approach every few years to have the "right" allocation is more likely to hurt returns than help them. Currency fluctuation might help you out; it might not--who knows.

The exception is countries with a lot of political risk. Investing in countries like Russia or Venezuela (pre-2008) offers a lot of risk that usually doesn't pay off--either your investment will go down in value or it will go up and some oligarch or "man of the people" will expropriate it. Either way, you lose.

Regardless, as long as you aren't 75% Russia, you're probably okay. :)
Last edited by stlutz on Fri Dec 23, 2011 11:50 am, edited 1 time in total.

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Re: Is Home Bias necessarily bad?

Post by Noobvestor » Fri Dec 23, 2011 2:37 am

Eferv wrote:Hi,

I haven't made my allocation decisions yet but I'm loosely modeling the Swenson Portfolio, which allocates 30% to US stocks, and then only 15% and 10% to Foreign Developed & Emerging Markets.

This looks like a home bias. Question is, is that bad? Swenson mentions that US stocks have the best risk-adjusted return and Emerging Markets the worst. Considering this, it makes sense to me that US gets a larger allocation, but maybe I'm thinking about this incorrectly.

Thanks
I assume he meant 'have had historically' - and I also assume he wouldn't say that was going to be true going forward, unless he has a better crystal ball than mine (which is fogged up like a swirly snowglobe!)

@Nis: I won't get into another spar over this, I promise, but I would point out that your 'optimum allocation' is both backward-looking and doesn't include non-stock assets - presumably most people with, say, 50/50 US/Intl are far less than 50% exposed to international once you account for their 25%+ bond allocation ;)

@Larry: good summary - I agree: home bias is more serious than people give it credit for ... and anyone who says we can't be the next Japan is kind of asking for trouble :(
My take is that he is concerned with the recent popularity of foreign stocks and that such popularity will lead to disappointment eventually among less experienced investors, if and when international stocks cool off. I believe he is also concerned that foreign countries may not have embraced capitalism and equity markets with the same level of long term conviction that America has. Other countries may or may not have the culture conducive to equities that we have. If this is true, is it really diversification?
All I can say is that the US markets are doing great this year, and my 'high' (still less than market weights, mind you) allocation to international still feels just fine to me :)
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe

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Re: Is Home Bias necessarily bad?

Post by peter71 » Fri Dec 23, 2011 7:50 am

dyangu wrote:
larryswedroe wrote: My advice is based on SCIENCE, peer reviewed research that shows ...
I'm sorry but macro economics is not a science. In science, we come up with a hypothesis based on logic and past experience and then test it in a double blind trial with a control group. In economics and investing research, we come up with a hypothesis based on logic and past experience. That's it. There are no controlled trials to validate a hypothesis.
While you're right to be suspicious of anyone who writes "SCIENCE" in all caps, neither science nor social science is limited to "experimental human subjects research." Though research on finance is particularly tricky, there are many situations in which logic plus good old-fashioned multivariate regression is quite instructive, to say nothing of more recent attempts by econometricians to use other statistical techniques to better approximate the experimental ideal. (See here for a relatively accessible introduction.)

http://www.amazon.com/Mostly-Harmless-E ... 0691120358

Best,
Pete

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Re: Is Home Bias necessarily bad?

Post by nisiprius » Fri Dec 23, 2011 8:19 am

stlutz wrote:Picking a percentage and stocking with it is the correct answer; changing you approach every few years to have the "right" allocation is more likely to hurt returns than help them. Currency fluctuation might help you out; it might not--who knows.
I agree.

One of the reasons I get such a head of steam up on this is the cadre of advice-givers changes their advice from decade to decade. At any point they have well-articulated answers as to why whatever they are recommending now is best, but give nothing but shoot-from-the-hip ex cathedra answers as to why their answer has changed.

Thus, in the 1990 edition of A Random Walk Down Wall Street, Burton Malkiel recommended 10% of equities be international. In 2007, he recommended 1/3. Currently, he recommends 1/2. I once emailed him asking for an explanation of the increase from 1/3 to 1/2, and he replied "What is happening is that the US share of the world economy is falling." (Unfortunately I wasn't aware of his 1990 recommendation when I asked.) (Malkiel and I are total strangers; I am just willing to send random emails to strangers in case they might answer, and he sometimes answers random emails from strangers).
Image
This is share of stock market, not share of economy, so not exactly what he was talking about. You may draw your own trend line through this data, from Vanguard's "Considerations for investing in non-U.S. equities," and certainly I see a downward trend, but in fact the U.S. stock market is a higher percentage of the world stock market than it was in 1990, and in any case, nothing in this chart explains why the recommended international allocation would change from 10% to 50% of total equities.

Surely "diversification" and modern portfolio theory were appreciated in 1990. And while the variety and quality of international stock funds has increased and cost has dropped, it's not by all that much. I don't think anything rational or scientific can explain a fivefold change in recommendation over that time period. In my jaded and cynical, opinion, there have to be elements of the following:
  • Fads, fashions, and opinion trends within an investment community--everyone thinks X because everyone else thinks it;
  • Recency effects, such as the weakening dollar from 2002-2008 making international stock funds look conspicuously good ("not a lost decade if you had an international allocation");
  • Self-sustaining cycles in which fund companies realize that investors are interested in international stocks, so they introduce more and more international products, so they send more and more press releases to the financial press which publishes more and more magazine articles about five new international funds with novel, nifty new features.
Last edited by nisiprius on Mon Dec 26, 2011 5:07 pm, edited 2 times in total.
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Re: Is Home Bias necessarily bad?

Post by larryswedroe » Fri Dec 23, 2011 9:29 am

To be clear I used the term science to mean the science of investing, and while it is not a hard science like physics, it is a social science. We have data and facts to rely on, and studies on human behavior as well to help us explain anomalies
And we know that Efficient Frontier Models are not very useful tools as very small changes in inputs lead to huge changes in output.
Common sense needs to be applied.
And also what makes sense for a US investor should also make sense for all investors--diversification of the economic and geopolitical risks of single country

Best wishes
Larry

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Re: Is Home Bias necessarily bad?

Post by BlueEars » Fri Dec 23, 2011 11:21 am

My hypothesis is that the current bias is toward reducing international allocations.

Recency is a strong force. This is based on the the 2011 returns which have been:
Vanguard Total International = -14.8%
Vanguard Total Stock Market = +0.8%

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Re: Is Home Bias necessarily bad?

Post by winguy » Sat Dec 24, 2011 1:26 am

larryswedroe wrote: IMO the right starting place is world cap weighting, then add small home country bias to account for higher costs of international funds and lower tax efficiency, so say 50% international instead of almost 60%. And 40% is better than 30 and 30 is better than 20.
Here's a video I came across a few months ago:
http://www.dimensional.com/famafrench/2 ... -bias.html

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Re: Is Home Bias necessarily bad?

Post by Valuethinker » Sun Dec 25, 2011 10:45 am

nisiprius wrote:

Thus, in the 1990 edition of A Random Walk Down Wall Street, Burton Malkiel recommended 10% of equities be international. In 2007, he recommended 1/3. Currently, he recommends 1/2. I once emailed him asking for an explanation of the increase from 1/3 to 1/2, and he replied "What is happening is that the US share of the world economy is falling." (Unfortunately I wasn't have his 1990 recommendation at hand when I asked.) (Malkiel and I are total strangers; I am just willing to send random emails to strangers in case they might answer, and he sometimes answers random emails from strangers).
Weighting the US by 'fundamental indexing' is what Arnot talks about and has implemented. That's the idea of weighting a country by its GDP not its market cap.

This seems fundamentally flawed. If we believe markets are efficient, then the value of the S&P500 also includes a valuation of the value S&P500 companies will reap from emerging markets.

Either directly via investments OR

indirectly. Eg because WMT imports from China, consumers have more money in their pockets due to cheaper goods, WMT benefits.

So the US share of global GDP is 'in the price'.

In practice, US S&P500 is light raw materials producers (plenty of oil &gas, not much metals and mining) relative to some other indices. It's heavy healthcare and technology. Perhaps a bit light on heavy industry relative to say, Germany.

So there are certainly gains arising from *sector* diversification via international investing. Separate from country diversification.

Some companies are very domestic in nature (some banks, housebuilders, healthcare companies) and some are utterly international (JPM, GE, P&G, Pfizer etc.).

To try to second guess market valuation on this seems to me to be counterproductive, particularly using a 'rising GDP of China' argument.

FWIW Indian companies always looked more interesting to me than China. Greater transparency and I have a greater understanding of what is going on in India- the culture and economy are more transparent to a western set of eyes. There's less of a sense of a giant rigged game that the CPC is running with the national economy, with external foreign investors really only there because of their utility. At some level, magnificent though it is, what is happening in China defies my understanding.

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Re: Is Home Bias necessarily bad?

Post by VictoriaF » Sun Dec 25, 2011 11:13 am

ilmartello wrote:
bottlecap wrote:I think the biggest risk you face if you don't have a home bias is currency risk, since you will be spending your home country dollars in retirement (unless you've done really, really well :wink: ), but perhaps someone else can confirm this?

JT
A lot of goods people purchase now are imported, so I don't understand the logic on this.
People spend a lot on services, not just goods, and the services are usually local. Even the price of goods has a large component of services, e.g., shipping, stacking, storing, arranging, marketing, selling, etc.

This service component makes some preference to the home-country currency and investments justified for any country, not just the U.S. I would avoid the expression "home country bias," because the word "bias" has a negative connotation; it seems to point to simple-mindedness and lack of sophistication. Yet, there are some good reasons for allocating in the U.S. markets above their global market cap or GDP percentage that have nothing to do with biases.

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Re: Is Home Bias necessarily bad?

Post by BlueEars » Sun Dec 25, 2011 11:58 am

Victoria, I like your reasoning. Thanks.

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Re: Is Home Bias necessarily bad?

Post by Fclevz » Sun Dec 25, 2011 6:04 pm

VictoriaF wrote:People spend a lot on services, not just goods, and the services are usually local.
Just to clarify, when you mention services such as shipping, I would think that the value of UPS or FedEx or whatever already priced into the market and so already at the 'correct' market allocation?
Or, are you referring to services that are provided by non-public companies (i.e. can't buy their stock in the open market)?

Cheers,
Fred

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Re: Is Home Bias necessarily bad?

Post by getRichSlower » Wed Jan 04, 2012 10:05 pm

Foreign equities are fundamentally riskier for a US investor. Suppose that the worst possible sustained stock market crash is 80% in both the US and Europe. An all US portfolio can go no lower than an 80% loss. However, if Europe crashes 80% and the dollar doubles in value against the Euro, then your international stocks can go down 90%. I am assuming that any stock crash worse than 80% leads to a guns, land, and gold type of situation, that I want to stay away from discussing. US investors need international exposure, but global market cap weightings seem extreme.

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Re: Is Home Bias necessarily bad?

Post by umfundi » Wed Jan 04, 2012 11:49 pm

Is Home Bias necessarily bad? Yes, because it is a prediction.

You diversify your investments to spread your bets and decrease volatility.

"Home bias" is a prediction, you cannot possibly know. Pick some mix of US vs. International, rebalance at least annually.

You don't have to predict where your goods will be made or where you will be spending your money. If you knew, you would go 100% for one option or the other.

Keith
Déjà Vu is not a prediction

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Re: Is Home Bias necessarily bad?

Post by Valuethinker » Thu Jan 05, 2012 4:29 am

VictoriaF wrote:
ilmartello wrote:
bottlecap wrote:I think the biggest risk you face if you don't have a home bias is currency risk, since you will be spending your home country dollars in retirement (unless you've done really, really well :wink: ), but perhaps someone else can confirm this?

JT
A lot of goods people purchase now are imported, so I don't understand the logic on this.
People spend a lot on services, not just goods, and the services are usually local. Even the price of goods has a large component of services, e.g., shipping, stacking, storing, arranging, marketing, selling, etc.

This service component makes some preference to the home-country currency and investments justified for any country, not just the U.S. I would avoid the expression "home country bias," because the word "bias" has a negative connotation; it seems to point to simple-mindedness and lack of sophistication. Yet, there are some good reasons for allocating in the U.S. markets above their global market cap or GDP percentage that have nothing to do with biases.

Victoria
The reason to have a 'home country bias' is your *liabilities* are in your home country.

Chiefly, for a USian, housing and healthcare (home care when you get very old). Education of your kids. Etc.

All the things for which we save.

Now many/ most have significant non-currency-diversifiable assets in their home currency:

- housing equity
- Social Security income stream
- Medicare

For a USian, the problem of home country bias is, to my mind, not large. You are 45% of the world's stock markets by capitalization.

If you are invested 60/40 equities/ bonds, and 30-50% of your equities are invested outside the USA then:

- you are c. 20% in non USD assets (but many currencies track the USD, many S&P companies are diversified outside the USD)
- historically 20-30% non USD assets has generated the best portfolio diversification

For a non USian, the case for simply weighting by world market cap (ie tilting towards the US) is pretty strong: none of the rest of us live in such a large currency area/ economy (the Euro and the Yen, but all the known problems of same-- Euro is a currency, not a country, Japan has its own set of problems).

If you are going to retire abroad or travel extensively in retirement, there's a stronger case for more foreign assets. But don't overdo it in the latter: it's hard to imagine that more than 20% of *all* your spending (rent, gasoline, food, property taxes, healthcare etc. etc.) is going to be outside the USA in retirement. unless you live outside USA.

Foreign bonds probably add to diversification in theory, but in practice are not worth all the issues: you are adding an asset which, if unhedged, can have volatility approximating that of domestic equities, but not the returns. If hedged, then the gain (see Swensen) probably does not overcome the costs, for a small investor (I'd be interested to see what DFA says to its clients on this).

On Services

The argument is made that of a $160 iPod, something like $45 is actually accruing in China. The rest is accruing to:

- component suppliers - typically Taiwan, Japan, South Korea, Thailand etc.
- distributor and retailer ie Apple

So even in common manufactured goods, most of the value is accruing in the country of destination.

Consider a car say. If the wholesale price is 80% of the retail price, then that 20% is accruing to the shipping and the dealer. Which is far more than the manufacturer makes (2-4% net margin, before tax; BMW makes about 8% I think; volume car makers 2-3%). Then there is the servicing (say 50%+ to the dealer) etc.

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Re: Is Home Bias necessarily bad?

Post by Valuethinker » Thu Jan 05, 2012 4:39 am

getRichSlower wrote:Foreign equities are fundamentally riskier for a US investor. Suppose that the worst possible sustained stock market crash is 80% in both the US and Europe. An all US portfolio can go no lower than an 80% loss. However, if Europe crashes 80% and the dollar doubles in value against the Euro, then your international stocks can go down 90%. I am assuming that any stock crash worse than 80% leads to a guns, land, and gold type of situation, that I want to stay away from discussing. US investors need international exposure, but global market cap weightings seem extreme.
Actually not. In that the UK had an over 80% crash in the 1973-74 period. It was a time of 20% inflation, strikes, threatened IMF bailout, but it wasn't a collapse of law and order (Northern Ireland was not pretty and we had significant IRA terrorism on the Mainland, but still). We even had power rationing (the Coal Miners Union went on strike, and with secondary picketing, blocked supply to the power stations)-- the 3 day working week (3 x 12 hours and productivity went *up*: no tea breaks).

Don't assume that it's end-of-the-world-stuff just because markets go down a lot. It will feel like it, to be sure. But countries have had that kind of experience without war, Revolution etc. Argentina for example was bad during the default, but not guns, land, gold. Neither was Russia during its meltdown, although law and order was a problem.

The point about using world market cap weightings around here is that most probably have US only fixed income. So 55% foreign equities might translate to only 30% of total assets.

Empirically 20-30% foreign equities has tended to lead to most diversification/ least volatility ie closest to Efficient Frontier. Correlations of developed market equities with USA have increased steadily and during a bear market, move to 1.0-- ie diversification benefit has fallen.

If one could find a good small cap value product (DFA probably the only one) international, then one can gain greater diversification benefits (and therefore have a lower allocation): that's more or less what Larry Swedroe does personally, I believe.

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Re: Is Home Bias necessarily bad?

Post by Valuethinker » Thu Jan 05, 2012 4:43 am

VictoriaF wrote:
ilmartello wrote:
bottlecap wrote:I think the biggest risk you face if you don't have a home bias is currency risk, since you will be spending your home country dollars in retirement (unless you've done really, really well :wink: ), but perhaps someone else can confirm this?

JT
A lot of goods people purchase now are imported, so I don't understand the logic on this.
People spend a lot on services, not just goods, and the services are usually local. Even the price of goods has a large component of services, e.g., shipping, stacking, storing, arranging, marketing, selling, etc.

This service component makes some preference to the home-country currency and investments justified for any country, not just the U.S. I would avoid the expression "home country bias," because the word "bias" has a negative connotation; it seems to point to simple-mindedness and lack of sophistication. Yet, there are some good reasons for allocating in the U.S. markets above their global market cap or GDP percentage that have nothing to do with biases.

Victoria
Think about a US retiree, buying:

- housing services - either they own their own home (imputed rent is a housing cost) and pay property taxes, utilities, maintenance OR they rent
- insurance services
- financial services
- medical services
- transport services - the whole world pays the same gasoline price (differences are about taxes, subsidies and minor transport costs), but of course there are the taxes and road tolls, car servicing, insurance etc.; US domestic airlines; trains & buses
- food - US is a major food producer, and most of the price of food is the markup arising from distribution and retail sale

That must be 80%+ of the spending of a US retiree.

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