Stock asset allocation for non-US investors

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Stock asset allocation for non-US investors looks at how an investor domiciled outside of the US might decide on their asset allocation within stocks.

Introduction

When deciding on their stock allocation, every investor needs to make a number of decisions:

  • What regional allocation will I adhere to?
  • Do I want global diversification?
  • Do I overweight one region?
  • Do I overweight my region and introduce a home country bias?

In addition, investors need to decide if they will focus on the mainstream Boglehead practices, or if they prefer one of the variations.

Worldwide or overweighting a region or country

One of the Boglehead principles is to diversify. The principle mentions that rather than trying to pick the specific securities or sub-asset classes of the market that will outperform in the future, Bogleheads buy funds that are widely diversified, or even approximate the whole market.

Owning the whole worldwide stock market

Owning the whole worldwide stock market seems to implement the diversify principle the most closely. It would mean to own large cap, mid cap and small cap stocks of the developed and emerging markets, covering about 98% of the worldwide stock market.[1]

Sometimes a simpler portfolio is warranted as, unfortunately, owning the whole worldwide stock market might require a complex and more expensive portfolio of multiple funds. Options include:

  • A focus on large cap and mid cap stocks of the developed markets only: covers about 75-80% of the worldwide stock market.[2]
  • A focus on large cap and mid cap stocks of the developed and emerging markets: covers about 85%-90% of the worldwide stock market and might be achieved with one or two funds.[1][2]

Home country bias

Home country bias is the overweight of your home country or region in your asset allocation. A simple reason for this is familiarity (and in many countries a lack of opportunity to invest elsewhere).

See: Home country bias from finiki, and Equity home bias puzzle from Wikipedia. An article in A Wealth of Common Sense discusses how the different regions of the world differ in terms of their market structure and composition and how the home country bias can impact the diversification, performance and risks of the portfolio.[3]

Overweighting the US market

Many US based Bogleheads overweight the US stock market. Both John Bogle in Common Sense on Mutual Funds[4] and Taylor Larimore in The Bogleheads' Guide to the Three-Fund Portfolio[5] argue for overweighting US stocks in a US investor's asset allocation policy by limiting non-US stocks to a maximum 20% of the total equity allocation.

This might also be a strategy for the non-US investors that subscribes to the same reasoning.

Studies

Global diversification on the finiki sister site

Global diversification is a type of geographical diversification that consists of adding foreign asset classes, such as stocks and bonds, to a domestic portfolio. The goal of global diversification can be to increase the expected return, decrease the risk, or both, although whether such goals will be achieved cannot be known in advance. This page explores the pros and cons of global diversification for fixed income and equities, from a Canadian perspective, but first explains the "home country bias" phenomenon.

Investing in the World blog series

Forum member Siamond posted an Investing in the World series on the Bogleheads blog Financial Page where he poses the question:

Could one simply invest in the world, using global stocks and global bonds? And if this proves unsatisfying, is there a proper middle ground between domestic and global allocations?

  • Part 1 studies a fairly extreme position of investing 100% in the world (global stocks and global bonds).

The outcome proved surprisingly diverse, due to very distinct (and hard to predict without hindsight) patterns in inflation and exchange rates in the various countries being investigated. The author concluded by the desire to look at more balanced asset allocations, involving domestic equities as well as global equities.

  • Part 2 explores the opposite position of exclusively investing with domestic assets. The article focuses on the historical returns from 16 developed countries, looking from the perspective of a local investor, and assuming a strong home country bias to begin with (that is, solely using domestic stocks and domestic bonds).

The study concludes that a fully domestic investment can deliver fairly good results, as anybody having invested in the US or Canada knows. It can even deliver very impressive results as Swedish citizens experienced in the past decades. But it can also put local investors in devastating situations, with decades-long drawdowns for both stocks and bonds (in real terms), and ruin even the most conservative retirement plans, as Spain, Italy and Japan investors went through.

  • Part 3 seeks a middle ground and looks at more diversified portfolios mixing domestic and global investments in the various countries of the study. It looks at the mitigation mixing domestic and global can bring to the countries having fared the worst, but also consequences for countries having fared better.

Generally speaking, a broad exposure to global stocks (while still keeping a tilt towards the domestic market and without introducing any such globalization on the bonds side) seemed a fairly solid approach, reducing the risk of large underperformance by being in a ‘loser’ country.

The author believes that this study makes a convincing case to seek a fairly high exposure to global (or international) equities, while keeping a significant tilt towards domestic equities.

Vanguard studies

Vanguard has several studies related to strategic asset allocation and home bias:

We found that market-cap-weighted indexed policy portfolios provided higher returns than the average actively managed fund. Furthermore, we suggest that global market-cap-weighted index funds are a good starting point for all investors.

Portfolio construction begins with investors choosing an asset allocation policy. Then, investors can choose how the policy will be implemented.

We also note that the average investor takes on a home-country portfolio bias. This may occur for many reasons, but perhaps three are the most prominent – inertia, return opportunity and risk control.

“In a world in which a portfolio’s diversification benefits from broad allocations to global securities, how much home bias is reasonable?”

Diversification is a common objective for global investors. But even though there is general agreement on the importance of exposure to a variety of asset classes (dependent, of course, on investor-specific factors), there is less agreement on the role of foreign securities in a domestic portfolio. Investors display a persistent and significant home bias, regardless of domicile, which often conflicts with the tenets of broad global diversification. It is interesting that this bias is often conscious and intentional, with investors actively overweighting domestic holdings at the expense of foreign securities.

When examining the equity allocations of European investors, in aggregate, we find that they hold significant overweights not only to their home-country market, but also to equities from broader continental Europe.

While European investors have been somewhat more willing to invest beyond their own borders compared to investors in other countries around the world, this study concludes that they would benefit from greater global diversification.

In light of empirical analysis and qualitative considerations, we have demonstrated that market-cap proportional diversification among global equities provides a reasonable starting point for European investors. Strict adherence to this principle would indicate an allocation to European equities close to 25%, with much smaller allocations to an investor’s home country. That said, we have also demonstrated that diversification benefits can be achieved through less than fully market proportional allocations. These higher allocations to European equities may also be considered reasonable because they would allow investors to benefit from exposure to both global and European equities while remaining sensitive to investor preferences. However, over time and as global markets become more integrated and home bias less relevant, this decision may warrant revisiting.

Regardless of where they live, investors have a significant opportunity to diversify their equity portfolios by investing outside their home market. Despite this opportunity, investors on average have maintained allocations to their home country that have been significantly larger than the country’s market-capitalization weight in a globally diversified equity index.

In each market we examined, our analysis indicated that volatility was reduced most with an allocation to international equities of between 40% and 50%. While this observation may help investors determine the appropriate mix of domestic and international equities, volatility reduction is not the only factor to consider.

This paper concludes that although no one answer fits all investors, global market-capitalization weight serves as a helpful starting point in determining the appropriate allocation between domestic and international equities. In practice, many investors will consider an allocation to international equities well below global market-capitalization weight based on their sensitivity to a number of considerations, including volatility reduction, implementation costs, taxes, regulation, and their own preferences.

Variations on Boglehead investing

Next to the mainstream Boglehead stock allocation there are a few often practiced variations on Bogleheads investing discussed on the forum.[note 1]

Within the US context several studies investigate the benefits and drawbacks of these variations. It is unclear if the conclusions that have been drawn for the US can be extrapolated to worldwide investing.

Notes

  1. Returns data for these US-based portfolios can be found at "Portfolios". Financial Page. https://finpage.blog/portfolios/.
  2. Rick Ferri provides details and variations of core four portfolios at Core-4®

References

  1. 1.0 1.1 "FTSE GEIS Product Highlights". FTSE-Russell. http://research.ftserussell.com/products/downloads/geis-cut-sheet.pdf., retrieved September 20, 2019.
  2. 2.0 2.1 Dominique Riedl (11 June 2019). "MSCI vs FTSE: Which is the best index provider?". JustETF. https://www.justetf.com/uk/news/etf/msci-vs-ftse-which-etf-provider-is-the-best-index-provider.html., retrieved September 20, 2019.
  3. "How the U.S. Stock Market is Unique". A Wealth of Common Sense. https://awealthofcommonsense.com/2018/01/how-the-u-s-stock-market-is-unique/., retrieved October 7, 2019.
  4. John Bogle (December 2, 2009). Common Sense on Mutual Funds. Wiley. ISBN 978-0470138137
  5. Taylor Larimore (July 3, 2018). The Bogleheads' Guide to the Three-Fund Portfolio. Wiley. ISBN 978-1119487333

See also

External links