Objections to investing in global equities
Akweli Parker: Hello, and welcome to Vanguard’s Investment Commentary Podcast Series.
I’m Akweli Parker. In this month’s episode, which we’re recording on August 21, 2015,
we’ll take a look at biases people can have against global stock investing. Today, the news
is from Europe and China, making some investors nervous about investing in stock markets
outside their home country. How much of that trepidation is warranted? Here to help
us examine that question in an analytical light is Kim Stockton, an investment analyst in
Vanguard Investment Strategy group. Kim, welcome to the program.
Meet the speaker
Kim Stockton: Thank you, Akweli. Happy to be here.
Akweli Parker: So, Kim, broadly speaking on this topic, what would you say about any
aversion that someone might have to investing outside the United States?
Kim Stockton: Yes, well, I understand the headlines can be ominous. We need to keep in
mind that there will always be exaggerated headlines focusing on unexpected and extreme
events. That won’t change, but the countries generating those headlines will likely change.
Today, it’s Greece and China. A few years ago, geopolitical risk from countries like Iran and
Egypt made the headlines.
The key for the investor is to not to get too caught up in this news and to focus on their
long-term objective, which likely hasn’t changed. And rather than avoiding one asset class
because of current extreme unexpected events in one or two countries, we suggest
focusing on the potential long-term benefits of a broad-market, global approach. And this
is where advisors can add a lot of value, providing their clients with the discipline to stay
focused on their strategic objective in the face of these concerning headlines.
Akweli Parker: Great. Let’s define some terms that are relevant to this conversation. Let’s
start with home bias. What is it, and is there anything wrong with it? I mean, after all, isn’t
it one of the pearls of investing wisdom that one should invest only in what you know?
Kim Stockton: Home bias is the tendency for investors to overweight domestic allocations.
Local investors across the world are influenced by home bias. This can be a result of
regulatory constraints, like limits on public pension funds’ allocations outside of their
domestic markets, or behavioral tendencies, such as the fact that investors are just more
comfortable with what they know, as you point out.
Akweli Parker: That’s an interesting point. Can you give us some examples?
Kim Stockton: Yes. For example, the U.S. equity market cap is about 49% of the global
equity market, yet U.S. investors have 71% of their assets invested domestically. The U.K.
equity market is roughly 8% of the global equity market, yet U.K. investors have about
50% of their assets invested at home. And in Australia, resident investors have a 70%
overweight to domestic equities relative to their 3.5% share of the market. The thing to
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Kim Stockton
Vanguard Investment
Strategy Group
keep in mind is that while the domestic stock market may offer the comfort of familiarity,
investing domestically and internationally can really benefit those with long-term perspective
in a number of ways.
A portfolio heavily concentrated in domestic stocks could exclude opportunities presented by
leading companies in emerging and other developed markets. Also, a domestic-heavy portfolio
may differ in sector allocations from a globally diversified portfolio, and these differences may
increase risk compared with that of a global stock market portfolio.
Akweli Parker: Okay, let’s talk about another term that we hear bandied about often in this
conversation, and that is headline risk. Can you tell us what that is, and is it anything that
long-term investors or their advisors should be concerned about when they see it?
Kim Stockton: Yes, headline risk is the risk associated with the possibility that a news story
will adversely affect a stock or the market. And I know this can be difficult in the face of
these daunting headlines, but we suggest that investors faced with bad economic or financial
market news, again maintain a long-term perspective and remember that investing part of a
stock portfolio in international markets has historically reduced volatility relative to a 100%
U.S. stock portfolio.
If there were no risk, potential investment rewards would be small or nonexistent. Risk-free
assets, of course, typically offer only modest returns. Also, markets can change rapidly in
response to news, which is why timing is so difficult. And finally, news providers naturally
have a short-term focus. In contrast, investors should really be more akin to those of
historians, years or even decades long for their time horizons.
Akweli Parker: You know, I was in the news business for a while, so I can really attest to that
point about the short-term focus. Is there anything else we should know about headline risk?
Kim Stockton: One other point about headline risk is that investors shouldn’t try to time
these events. I know some investors may be thinking, “Well, I think there’s going to be more
unrest in Europe so I’m going to pull out. I’ll try to get back in when things calm down.” But
to be successful with that approach, an investor would have to know exactly when the unrest
is going to be over, or when the ECB [European Central Bank] is going to react. So really, the
bottom line: Stay invested globally and maintain diversification.
Akweli Parker: Fantastic. Well, here’s an argument that comes up fairly often in this
discussion, and that is, aren’t you already exposed to global equities markets by virtue of so
many quote/unquote “U.S. companies” really being multinational in nature, at least when we
talk about their operations, their foreign operations?
Kim Stockton: Yes, yeah, so the thinking there is that because many large U.S.-domiciled
multinational companies like McDonald’s or ExxonMobil generate a significant portion of
their revenue from foreign operations, that the diversification benefits of global investing are
already reflected in their prices—in the performance of large U.S. firms.
While this aspect of globalization does certainly have an impact on investor portfolios, we
believe it still makes sense for investors to hold non-U.S.-domiciled investments for several
reasons.
First, simply focusing on U.S.-domiciled companies means an investor has no stake in leading
global companies that are domiciled in other countries, companies like Samsung, or Toyota,
or Nestlé. Second, many firms hedge away currency fluctuations of their foreign operations.
Although this can help to smooth revenue streams, foreign exchange can be a strong
diversifier for U.S. equity investors. And lastly, a portfolio made up solely of domestic firms
could be lacking industry diversification.
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Akweli Parker: Let’s talk about China for a minute. Its currency has been devalued, and its
stock market value has been plunging. Some have compared investing in China right now to
trying to catch a falling knife. We’re not really sure, at this moment, when things will stabilize.
So with all that in mind, what’s your take on the prudence of having exposure to Chinese
stocks?
Kim Stockton: Yes, China has certainly been in the headlines a lot these days. But what we
need to keep in mind is that while China’s equity market is now the world’s second-largest by
listed market cap, it’s still an emerging market. And as such, investors should expect to see
more pronounced ups and downs than they might in developed markets.
China is one of the world’s key emerging economies. It’s got the world’s second- largest
GDP. China accounts for 11% of global trade and 8% of global consumption. As a result, we
believe China can offer significant long-term benefits for investors.
At the same time, any emerging market represents greater risk. So we also encourage
investors to keep their portfolios balanced among other asset classes.
Akweli Parker: Thanks for that reminder of what a large and important piece of the global
economy China represents. Is there anything else you’d like to mention on this topic?
Kim Stockton: Yes, just a reminder that there is no one optimal, quantifiable, global allocation.
Historical and expected diversification, global market cap, home bias, and individual risk
tolerance all play a role. We can tell you at what allocation the historical diversification benefit
has been maximized and what we expect going forward, but after that, risk tolerance and
home bias considerations move the dial to the allocation that best matches the investor’s
willingness and ability to take risk.
For example, in the U.S., for equities, 30% of the total equity allocation to non-U.S. equities is
a good starting point, with an upper limit based on global market cap subject to the investor’s
risk tolerance.
Akweli Parker: Great. That sounds like a good note on which to close our conversation on
objections to global stock investing. Kim Stockton, thanks once again for being with us today.
Kim Stockton: My pleasure.
Akweli Parker: And thank you for joining us for this Vanguard Investment Commentary
Podcast. Be sure to check back with us each month for more insights into the markets and
investing. Thanks for listening.
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