What Is the Right Amount of International Diversification?

Clear Heads
Tuesday’s column elicited this response in the comments section: “Gee, all this mumbo jumbo … I could have had a V-8 and vodka with plenty of ice … I may have awoken with a headache but I wouldn’t have gone to bed with one … “

Fair enough. That article came without cost, calories, or potential liver damage, which are three tallies in its favor when compared with the commenter’s usual method of achieving a headache. However, it buried the central point—that while the famed Capital Asset Pricing Model suggests that all stock investors should own the same U.S. stock portfolio, real-world considerations argue otherwise. Sorry about that.

I will address today’s topic of international diversification more directly.

Two Extremes
The first thing to note is that Tuesday’s argument against the CAPM continues to apply. Given certain assumptions, some have argued that all investors around the globe should possess a single portfolio, which consists of an index of all publicly traded stocks and bonds. (For purposes of this discussion, we’ll ignore other asset classes, as well as private securities.) However, those assumptions do not hold in practice, rendering that recommendation moot.

(For the clearest words ever written by a Nobel Laureate about investments, I recommend Sections 3 and 4 of “A Global Capital Asset Pricing Model”, co-authored by Professor William Sharpe. Those passages will induce no headaches.)

In addition, there is the added complication of currencies. Famously, Jack Bogle has stated that because U.S. investors pay their obligations in dollars, they should invest in dollars. This implies U.S. investors should own only domestic securities. (They could also buy issues from countries that peg their currencies to the dollar, but that brings the risk of damage caused by sudden devaluations.)

That advice has been widely derided, as exemplifying an old-school mentality that might have been appropriate when the United States was the economic superpower, but which is hopelessly outdated today. Well, maybe. Then again, Bogle has not made a habit of being outmoded (aside from perhaps his criticism of exchange-traded funds, depending on your view of the matter), and in this particular opinion he is joined by Warren Buffett. Generally, I don’t favor appeals to authority—but I make an exception when Bogle and Buffett join forces.

That gives us two initial international-allocation policies, one supported by a Nobel Prize winner (along with some other academic notables), the other backed by the nation’s two most-credible investor advocates, who also have glowing academic records (Bogle being a Princeton graduate, and Buffett being the finest student that Ben Graham ever tutored). The first policy, that of owning the world stock and bond portfolio, leads to placing 62% of assets outside the U.S. The second policy leads to zero.

Who are you going to believe, the people advocating more than 60%, or those who say zero?

The Center Line
The answer, in practice, is usually “neither.” Many investors (your columnist raises his hand) hold few international securities, but that shortage arises from neglect rather than intention. Push them, and they will confess that yes, they should be better diversified, but they just didn’t get around to doing it. Their ideal position is greater than zero. But smaller than the world market weighting. Even the most globally minded of U.S. investors hesitate to go that far.

That, pretty much, is the science behind international diversification. Informed parties have arrived at radically different conclusions; neither investors nor their advisors care much for either answer; and thus a consensus has developed to split the difference, by investing 30% or so outside the U.S., and keeping the rest at home. The discussion is often high-minded and laden with data, as in this Vanguard paper, but make no mistake: The final choice, ultimately, is arbitrary. It rests on intuition, not science.

Two Potential Benefits
That said, there are two pretty good reasons to observe the consensus, by landing somewhere between the two extremes.

The first is the traditional claim made for international investing, which is that it diversifies economic and political risk. If security prices in one’s home country plummet, either because the economy collapses (high unemployment and/or inflation being the two likeliest culprits) or because of political instability, then solace can be found elsewhere. That proposition is simplicity itself, and it has protected many an investor over the years.

However, the usefulness of such an insurance plan has been declining, and steeply at that. We all know why: Each year, the global economy becomes more interconnected, not only because the giant multinational firms grow ever stronger ( Apple (AAPL),   Toyota (TM),  Google (GOOG), and so forth), and generate their revenue across so many borders, but also because manufacturing is widely spread. If Samsung’s sales slow, South Korea will scarcely be the only country to feel the chill. The company’s largest mobile-phone factory is in … Vietnam.

That logic holds particularly true for U.S. investors. These days, it remains possible, albeit improbable, that a secondary financial market such as Australia or Sweden could perform much worse than the global averages. And likelier yet for a tertiary market. But it is difficult indeed to see how the U.S. could fail while others remain standing. Certainly, that did not occur in 2008, when international diversification yielded no advantage.

So, while above zero, the economic/political payoff to U.S. investors for buying the securities of companies (or governments, in the case of bonds) that reside elsewhere isn’t very high. On that subject, my sympathies lie largely with Buffett/Bogle. The greater benefit of diversifying internationally would seem to come from currency movements. As currency fluctuations are largely uncorrelated with stock and bond prices, owning multiple currencies rather than only the U.S. dollar will lower portfolio risk, all things being equal.

Of course, this being a messy topic, all things are not equal. Yes, portfolios become more stable as their holdings become less correlated. On the other hand, currency movements bring additional volatility, which makes portfolios less stable. The two effects work in opposite directions; which will prove the strongest remains to be seen, and is beyond the ability of anybody to predict.

Wrapping Up
In summary:

1) The desired amount of international diversification has not been proven.

2) Most investors split the difference, by investing considerably less than the high estimate, and more than the low estimate.

3) While this heuristic cannot be defended on scientific grounds, it does have some support from investment logic.

Sometimes, despite all the research that is conducted, all the time spent on the subject, and all the money that rides on the decision, the investment community can’t arrive at a “correct” solution. This would be one of those times.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.