INVESTORS CONFUSE THE FAMILIAR WITH THE SAFE

Baby Bell

Many investors avoid adding international investments to their portfolios because they believe international investing is too risky. Academics, however, recommend that investors add international assets to their portfolios because they actually reduce risk. International equities do not move in perfect tandem with domestic equities. Therefore, the addition of international stocks to a portfolio should reduce the volatility (risk) of the overall portfolio. A study published issue of the Journal of Investing sought to determine whether international equity diversification actually provided that theoretical risk reduction benefit.

• A combination of the S & P 500 Index and the EAFE Index outperformed either index individually-a result of the low correlation.
• Increasing the international allocation to as much as 40% increased returns and reduced risk as measured by standard deviation (volatility).
• An allocation of 40% international produced the highest Sharpe ratio-a measure of the amount of return for a given level of risk.
• Increasing the international allocation from 0% to just 20% reduced the likelihood of negative returns by one-third.
• Investors with a 10% international allocation could be 98% certain that they would reduce risk by raising the international allocation.
• Investors with even a 22% allocation could be 90% certain that they would reduce risk by raising their international allocation.

What is likely to surprise most investors is that adding international assets to a portfolio during a period when they underperformed actually resulted in higher returns and lower risk.

Perhaps the most common argument I hear against international investing is that the regulatory environment created by the SEC makes the U.S. a safer place to invest. I fully agree that this is true. However, before believing that you can benefit from this information you must ask yourself if you are the only one that knows it. Obviously, the market is aware of, and security prices around the world surely reflect, this information. 

INVESTORS INTELLECTUAL CAPITAL

Allocating a significant portion of your portfolio to international asset classes will provide an insurance policy against potential problems in the U.S. Since we don’t have a clear crystal ball, diversification of risk is an important element of the winning strategy. If you need any more evidence of this just think about Japanese investors in 1989. Like U.S. investors in 2000, they may have seen no reason to diversify internationally. Their economy was king. Their technology was dominating the world. Their managed capitalism system was clearly superior to our more market oriented system. And, the Japanese stock market had far outperformed the U.S. and other global markets for 20 years. As we ended 2000, the Nikkei Index was still down approximately 70% from its level of over 11 years ago. Those who do not learn from history are doomed to repeat the same mistakes.

Sources:
1. Gus Huberman, Familiarity Breeds Investment, September .
2. Kenneth R. French and James M. Poterba, “International Diversification and International Equity Markets,” American Economic Review, vol. 81, No. 2, pp. 222226.
3.Gus Huberman, Familiarity Breeds Investment II.