User:Petulant/Domestic/international

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"Domestic/international allocation" refers to the specific investment policy question regarding how to allocate between securities from a domestic market and those from external or international markets. Typically, the phrase refers specifically to the allocation of the stock or equity portion of a portfolio, although rarely it can refer to allocation among diversified bond funds. Particularly for U.S.-based investors, low-cost index fund options for domestic and international stocks are often provided separately. Investors must consciously decide how to allocate the equity portion of a portfolio between domestic and international stocks. Often, the decision to allocate more of one's equity portfolio toward domestic stock than that stock's share of global market capitalization is called "home bias."

History
Several decades ago, investing in international markets came with higher costs and risks than exist today. Average investors had limited access to information or opportunities to invest in equities outside their home markets. If they did do so, unique tax or registration obligations could reduce the attractiveness of these opportunities. International investing thus incurred large costs and complexity, violating core principles of the Boglehead philosophy.

Over the last several decades, however, the costs and information problems involved in international investing have markedly decreased. Currently, for example, the expense ratio for Vanguard's flagship Total International Index Fund, Admiral Shares, is only 12 bps. For an investment of $10,000, the fee amounts to some $12 per year.

Over this period of falling costs and wider access, Jack Bogle, the inspiration for the Bogleheads movement, opined that U.S. investors still did not need to allocate any money to international stocks. He opined that currency risk was uncompensated risk and that U.S. institutions among the best for shareholders in the world. He suggested that if an investor did pursue an international allocation, it should be limited to 20% of the stock allocation. Similarly, U.S. investing celebrity Warren Buffet has opined that average investors don't need to invest outside the U.S. through international stocks.

Vanguard, however, has slowly increased its allocation to international stocks in its model portfolio products: target date funds and lifecycle funds. In X year, these funds generally allocated X% of stocks to international. As of 20XX, they allocated 40% of stocks to international. Likewise, Vanguard has also gradually released research papers supporting 20%, then 30%, then 40% of stock allocations being dedicated to international stocks due to their diversifying, risk-reducing impact on a portfolio. Other investment firms have followed the drift toward higher international allocations in model portfolio products. The majority of financial professionals recommend allocating anywhere from 20% of stocks, to market weight, or even 50% of stocks to international, touting their diversification benefits.

Given its evolution in the investing world, the question of domestic/international allocation presents one of the most controversial topics among Bogleheads.

Scope of Markets
1. Size and market cap of U.S., developed, and emerging markets. 2. Leading companies in U.S. and developed markets. 3. Sales shares of companies. -> implication, all are diversified for sales and exposed to global value chains, correlations are increasing. lines are blurred. U.S. is uniquely positioned as a large % of market cap with temptation to ignore. data indicates investors from all countries engage in home bias.

Diversification Benefits
1. CAPM application, flaws 2. Correlation, stdev and drawdown impacts. Note small magnitude even in Vanguard papers and rising correlation. 3. Efficient frontiers by time period. 4. missing winning companies

Types of International Funds
For U.S. investors,...total world, total international, developed/emerging, Pac/Europe, country-specific.

Proposed Justifications for Home Bias
Not all Bogleheads investors agree that declining costs have made the diversification benefits of international stocks attractive, or they may be skeptical of allocating investments to international stocks in line with their market capitalization. Skeptics of international allocation rely on a number of concerns addressed below.

1. Currency risks. Explanation. Currency as a boon. Reversion to the mean/PP, no evidence. Note that economics literature is not settled on impact of currency. Currency is complex. 2. Country risk. Political--Traditionally retaliation by receiving country, but could also be action by home country. Any one country is a small part of the global portfolio. 3. Governance--Even among developed markets, there could be greater alignment between company management and stakeholders other than shareholders, like employees, lenders, or the government. Home investors therefore may not trust governance of companies in other countries. 4. Liquidity/volatility issues. Especially in emerging markets, during difficult times capital outflows can result in depressed prices. Should not be a problem for long-run investors. 5. Higher costs. Expense ratios are somewhat higher, driven by emerging. Point out dividend withholding issues and limitations. Attempts to avoid specific countries/markets can be limited by options and targeting specific countries tends to have a high cost, though any one country is generally a small part of a global portfolio. 6. Behavioral risk. U.S. investors in particular often benchmark their performance against the S&P 500. Since diversification into international stocks can result in performance deviating significantly from the S&P 500, U.S. investors face significant behavioral risk of tweaking their asset allocation. 7. U.S. outperformance. Although specific to U.S. investors, some argue that U.S. institutions may foster outperformance by U.S. stocks compared to other countries. This could be tied to shareholder-centric governance norms, high levels of innovation, or the U.S. dollar's role as the world reserve currency. 8. Factor/regime explanations. Some argue that the benefits of international diversification may be able to be explained by specific causal forces like home currency weakness, different industry/factor composition abroad, and/or an overall economic regime in the home country. For example, Tyler Cowan (sp?) argues that international stocks provide the greatest diversification to U.S. investors when U.S. growth is low and U.S. currency is weak, assuming such international stocks are sufficiently driven by economic outcomes in other countries. Others argue that international stocks have greater sector exposure to industrials and financials than U.S. indexes, resulting in characteristics more similar to small/mid-cap or value indexes in the U.S. If these analyses are correct, cheaper or less risky substitutes for international stocks may exist, such as Tyler Cowan's proposal of gold or the proposal of tilts to U.S. small or value factors.

Expressing Home Bias
1. 0% allocation. Relevant when taking a strong position on risks/performance or where international allocation would be a small % of overall portfolio anyway. 2. Fixed percentage of equities. Simple to administer and limits any concerning aspects to a specified %. Not tied directly to market capitalization of domestic/international which can be dynamic. 3. Haircut approach. Recognizes domestic/international dynamic market caps. More work to balance since must identify the current market cap weight and apply a haircut. Rarely used. 4. Selective international stocks. Some investors may address the risks of international investing above by simply excluding stocks from markets that concentrate risks the most, such as China or other emerging markets. They can do so through allocations to developed market funds or other limited funds.

OLD Domestic/international allocation
According to a mutual fund tracking the [ FTSE Global All-Cap Index], a market-capitalization-weighted index designed to measure the market performance of large-, mid-, and small-capitalization stocks of companies located around the world, as of mid-2013 about 51% of the world's stock investment opportunities, as measured by market capitalization, are outside of the United States. See Figure 1. So it makes sense to consider diversifying your portfolio by taking advantage of the large asset class of international stocks. Today, focusing solely on the U.S. means you could be missing many attractive investment opportunities.

Moreover, according to Modern Portfolio Theory, "Systematic risk (a.k.a. portfolio risk or market risk) refers to the risk common to all securities—except for selling short as noted below, systematic risk cannot be diversified away (within one market). Within the market portfolio, asset specific risk will be diversified away to the extent possible. Systematic risk is therefore equated with the risk (standard deviation) of the market portfolio." One consequence of this is that the market portfolio is a starting point for most portfolios, and specific risk toward tilting to a home country should be taken with care and the choice to tilt made for conscious reasons.

Consider that in international markets you will find...


 * 7 of the 10 largest automobile companies
 * 7 of the 10 largest diversified telecommunications companies
 * 8 of the 10 largest metals and mining companies
 * 6 of the 10 largest electronic equipment and instruments companies
 * 5 of the 10 largest household durables companies

Despite the potential drawbacks of a perceived higher risk, the impact of currency fluctuations, higher investment costs, and an aversion to short-term underperformance relative to domestic markets, international stock investments provide a diversification benefit relative to an all-U.S. equity allocation.

The graph in Figure 2 shows relative investment return and volatility (standard deviation of return) for a U.S. S&P 500 index investment as well as an international EAFE (Europe, Australia, Far East) index investment. The graph shows the years from 1970 -- the first full year of the EAFE index -- to the end of 2008; a 39-year investment period. During the full period, the S&P 500 index had both a higher return and a lower standard deviation than the EAFE index. However, notice the non-linear curve of the graph. This graph shows what is known as an efficient frontier and shows that adding the diversifying effect of the EAFE portfolio (in 10% increments as denoted by the squares) to an all-U.S. S&P 500 portfolio actually increased return while also decreasing standard deviation. The 'most efficient' point being around a 70% S&P500/30% EAFE combination. But notice that adding anywhere from 1-40% EAFE resulted in an increased return with either a similar or lower standard deviation. However, it must be noted that this data is limited in time period and entirely backward-looking - it is unknown what the proper mix may be in the future based only on the past.

Of course, these returns are based on historical numbers for a nearly 40-year period. Looking at Figure 3, which shows the efficient frontier by decade, it is obvious that the optimal U.S./International allocation differs depending on the period. However, one thing is clear; combining both U.S. and International stocks has historically increased your return, decreased your volatility of returns, or both.

Figure 4 is similar to Figure 2. However, instead of using just the EAFE developed market international index, it combines that with international emerging market figures when they became available from 1988 onward. Figure 4 shows the even greater diversification effect of both developed and emerging markets stocks when added to an all-U.S. stock portfolio.

Another way to visualize the diversification benefits of holding both U.S. and international equities is shown in Figure 5. This graph shows the growth of an initial $100,000 investment over the period of 1972 to 2007. The S&P 500 index is representative of United States stocks, while the EAFE (Europe, Australia, and Far East) index is representative of developed international markets. The MSCI World index is comprised of all developed market countries. Their percentage in the index is weighted by their global market-capitalization, and so fluctuates in size as each country increases or decreases its world market presence.

Unlike the previous graphs mentioned, which held a static U.S. to international weighting, the MSCI World index shown in Figure 5 has fluctuated quite a bit with the U.S. comprising the majority of the index during the early periods, Japan dominating during the 1980's, and Europe gaining an increasing share more recently as the U.S. percentage has declined to about 45%. So while this graph may not be directly comparable to one showing a static U.S. to international allocation, what it does show is that, historically, holding a global-market weighted index has included a diversification benefit in that the investment return was higher than an all U.S. allocation, while its volatility (or standard deviation) was significantly tempered from that of an all international allocation.

The increased number of globally oriented equity funds such as Vanguard's Total World Stock Index Fund may reflect a shift in thinking regarding domestic/international equity allocations. Both because markets tend to move in different cycles and because you want to diversify your currency exposure, the need for both U.S. and international allocations is a common recommendation. With U.S.-based companies now deriving a significant portion of their revenue from overseas, and conversely, international companies making large portions of their sales in the U.S., the idea that you need to treat U.S. and international stocks as distinct assets has been somewhat blurred.

Main types of international funds
Some international funds select stocks from many countries, while others focus on a particular region or country. Still others select investments from countries with similar economic conditions, including the two major distinctive types of either developed markets or emerging markets.


 * A developed market exists in a country that is a fully modern industrial nation with a well-established stock market, such as most Western European nations, Canada, Japan, and Australia.
 * Emerging markets are nations evolving from an agricultural to an industrial economy or from a government-controlled economy to a free market, such as Argentina, Indonesia, Hungary, and India.

Not surprisingly, the risks are generally higher in the emerging markets, where governments and financial markets may be less certain. On the other hand, emerging markets may offer the potential for faster economic growth as well as market cycles that are less synchronized with the developed markets.

Risks of international investing
Currency risk. Investments denominated in foreign currencies decline in value for U.S. investors when the U.S. dollar rises in value against those currencies. Conversely, the investments rise in value when the U.S. dollar weakens. There have been prolonged periods when the dollar has weakened against foreign currencies and others when it has strengthened.

Country risk. Events in a specific country—such as political upheaval, financial troubles, or a natural disaster—can drive down the stock prices of companies in that country. You can reduce but not eliminate this risk by choosing an international fund that invests in many countries and has a strong focus on developed nations.

Liquidity risk. Sometimes foreign stocks can be difficult to buy or sell, in part because trading volume on foreign stock exchanges tends to be much lower than on U.S. exchanges. Liquidity risk means the fund manager may have trouble buying or selling stocks without causing their prices to rise or fall substantially. You can reduce this risk by focusing on funds that invest in many countries and on those with well-established financial markets.

Risks of home country investing
Currency risk. Currency risk can cut both ways. While we earn and spend most of our money in home-country currency, we also have many assets in that currency not accounted for within investing portfolios - future earnings (human capital), homes and other goods - thus, the need to minimize foreign-currency exposure may not be as great as it first appears from a portfolio-only perspective.

Consider two common cases: a young investor who is mostly in stocks is also heavy on human capital in general, while an older investor who has moved toward more (home-country) bonds has less human capital but also less equity exposure in general. In either instance, currency risk is mitigated by elements seen and unseen. Thus, many if not most glide paths provide less currency risk upon closer inspection, once an individual's entire financial situation is accounted for.

There is no expected return to currency diversification in itself. However, some degree of zero-expected-return diversification (e.g. currencies, commodities) can be beneficial to a portfolio's total risk/return profile. Finally, some people plan to spend money abroad at points in their life, making other-currency holdings potentially advantageous.

Country risk Again, this is a risk that cuts both ways. As illustrated in the previous section, country-specific risk is a concern for portfolios. This is not, however, limited to foreign countries. No matter how strong and developed a single market may seem, there are cases (like Japan) in which the market has underperformed for decades. So far in the 2000s, the United States has underperformed the global market, for instance, as well.

Liquidity risk In an effectively efficient market, one should presume that liquidity risk is a factor in returns - or to put it another way: the market has priced in such risks and provides expected rewards in return for them. The best way to control equity risk is, in general, not to avoid a subset of equities, but to hold more assets in bonds or cash-like instruments for diversification.

Suggested allocations
Determining an appropriate domestic/international allocation is a subject of much debate. See: Combining domestic and international stocks.