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October 29, 2020October 29, 2020

Don’t Forget International Stocks

I received a question from a long-time reader, noting the multi-year underperformance of non-US stocks relative to US stocks.

Over a 10-year interval, he noted, international stocks very rarely outperformed US stocks, and concluded that it “makes me wonder why any asset manager would invest more than a token amount in international stocks, funds, or ETFs.”

I wildly disagree with his conclusion, but it is a great question. What exactly is the point of investing in international stocks, especially those that just seem to do worse than US stocks over a decade?

To begin, can we nerd-out for a moment on portfolio theory? We start with the first principle that we choose assets because they offer a return. But unfortunately, they also carry some risk.

Stars_and_stripes — Patriotism is not a good portfolio reason to own only American

As a second principle, we also assume that we want to maximize returns, while minimizing risk. More returns = good. More risk = bad.

Portfolio theory says that you can accomplish the goal – more returns and lower risk – by owning more than one investment.

If you have two (or more) investments (or mutual funds, in our analysis) that are not perfectly correlated, then portfolio theory says that you improve your combination of risk and return – as a combination, as a portfolio – when you combine these two (or more) assets.

The key ingredient to this recipe working is non-correlation between the investments. In non-technical terms, when one asset zigs, the other one zags. Underperformance during some period of time with one asset will be offset and blended with outperformance of the other asset.

When you combine a US-based mutual fund with an international-based mutual fund, portfolio theory does not promise you better returns. Instead, it promises that the combination will, over time, get you closer to the maximum return on your portfolio for a given level of blended portfolio risk.

To be sure, the highest returns possible often come from concentrated, undiversified, investments. However, those returns may come at a cost of higher risk than may be prudent.

The theoretical language we use (I mean, financial theorists use) is approaching the “efficient frontier” of risk and return, through diversification.

The clearest explanations I’ve ever read of this comes from a 2013 book by Lars Kroijer, Investing Demystified: How To Invest Without Speculation and Sleepless Nights, which carefully threads the needle between plain language and an academic financial nerd festival. Which is to say, I recommend it.

Kroijer offers strong advice that directly addresses my reader’s question about whether to bother with both international and domestic funds. His advice, which I endorse, is that there is no rational reason to have more US stock exposure than the proportion of global stocks that are based in the US. Which, if you’re curious, is about 37 percent right now. I’ve never met an American stock investor who had such a low percentage of stock investments in their portfolio. But I present it as an anchoring idea, in order to be challenging. In my stock mutual fund portfolio, I’m at 60 percent US, 40 percent international. Which, again, I’ll guess is still more international than most.

A historical note. Japanese investors experienced approximately zero price appreciation if they bought only the Nikkei 225 Index 30 years ago, versus a roughly ten-fold appreciation in prices of the US-based S&P 500 Index. Including dividends, the 30-year return on the Nikkei versus the S&P 500 is roughly 50 percent versus 1800 percent, respectively. I’m not adjusting for inflation here.

For Japanese investors, owning only the main stock index of their own country would be a very expensive choice, over this 30 year long run. The point is not that Japanese stocks are bad and US stocks are good. The point is that owning only investment assets from your own country can be an extremely poor decision. Which you only learn in retrospect.

People who grow up in countries outside the US and who have an appreciable net worth rarely make this same choice. They hedge their risks by owning non-domestic assets, stocks, real estate and currencies. Wealthy Mexican nationals who lived through the 1982 banking crisis or the 1994 currency crisis wouldn’t dream of owning only Mexican assets denominated in Mexican pesos. Wealthy Brits who lived through the pound devaluation in 1992 feel the same way. Or wealthy Russians during the 1998 devaluation. Same with anyone who grew up anywhere in Latin America at any time in the last one hundred years. You get the idea.

Lots of easy caveats and corrections may be applied to this theory of international diversification I’ve presented. One, for example, is that many US multinational companies provide exposure to developed and emerging market economies, so that a US-based portfolio still has quite a bit of global exposure embedded in it. Ok, sure, I partly agree.

Another argument is that a strong tradition of rule of law and regulatory protection makes US-investing inherently superior to non-US investing, for now and for the foreseeable future. I don’t disagree with the initial observation, but I would argue that prices, market capitalization, and future returns will efficiently reflect those institutional differences, over time. Including, especially, in the future.

At the risk of being accused of unpatriotic thoughts, I would also argue that US exceptionalism was real in the past, may still mean something in the present, but isn’t something I would permanently bank on for the future. A main point of portfolio theory investing is that we don’t know what will happen in the future. We can’t control the future, but we can manage our risk and return – as close to the efficient frontier as possible – through diversification.

Another key caveat is that international stocks have become more correlated with US stocks over the past few decades, so we achieve less non-correlation in recent years than we would want from non-US investing. That’s not a reason to not diversify, but rather, a reason to stay vigilant about correlations.

If you broaden your risk examination beyond the stocks you own to think about other financial risks – risks of real estate you own, risks to your income, and risks to your currency exposure, you might realize that many of your eggs are kept in the same US, dollar-denominated basket. Your risks actually stack on top of one another in a correlated way. For portfolio theory to give you the best returns at a given risk, you want to seek out less correlated, or non-correlated, risks.

So, in sum, even if your international stocks have underperformed your US stocks, it doesn’t mean you should give up international exposure in your portfolio.

To restate, for emphasis: The majority of US investors are woefully underinvested in non-US assets. We are exposed to our own country’s risk to a degree people from other countries – from hard-won experience – would never, ever, dream of being.

A version of this post ran in the San Antonio Express-News

Please see related posts:

Book Review: Investing Demystified by Lars Kroijer

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May 8, 2014

Guest Post: The Simplest Investment Approach, Ever

Editor’s Note: Lars Kroijer is a former hedge fund manager, and the author of two books. He previously posted here on the advantage of conceding ‘edge’ in personal investing. I appreciate his debunking the value of high-cost financial services.

You probably can’t outperform the market – here is how you should invest once you accept that

As investors we are bombarded with stock tips about the next Apple or Google, read articles on how India or biotech investing are the next hot thing, or are told how some star investment manager’s outstanding performance is set to continue. The implicit message is that only the uninformed few fail to heed this advice and those that do end up poorer as a result. We wouldn’t want that to be us!

do_you_have_an_investing_edge — Do YOU have an edge investing? Doubtful.

What if we started with a very different premise? The premise that markets are actually quite efficient. Even if some people are able to outperform the markets, most people are not among them. In financial jargon, most people do not have edge over the financial markets; they can’t consistently outperform the market by picking different securities / sectors / geographies from the market as a whole, especially after costs. Nor are they able to pick which of the thousands of fund managers have the ability to do it for them. Accepting, embracing, and acting on this absence of edge should in my view be a key moment in most investor’s lives.

The absence of edge does not mean that you should avoid investing. Doing so would exclude you from potentially exciting long term returns in the equity markets, or benefitting from the security of highly rated government bonds. Also, what else were you going to do – leave your money under the mattress or in a bank at zero interest? Instead we should assume that the current market prices of securities capture all available information and analysis, and that the price reflects that security’s future risk/return profile. In equities we should then pick the broadest possible selection of stocks because just like we don’t know which one stock will outperform, we don’t know which sector or geography will outperform.

And what is broader than an index that track equities from all over the world in the proportion of value that market forces have already put on them? With a world equity index tracker we maximize diversification and minimize exposure to any one geography, sector, or currency. And since we simply track an index (like the MSCI All Country World, etc.) it is very cheap to put together for a product provider like Vanguard, iShares, etc., and thus cheap to us. If an all equity exposure is too risky, you can combine this world equity portfolio with government bonds in the proportions that suit your risk profile. The lower the risk desired, the more bonds you want.

global_etf_investing — How much of the world equity market to invest in? All of it

So my key takeaways to most investors can be summarized as follows:

You almost certainly do not have edge in the financial markets. That’s ok. Most people don’t, but you should plan and act accordingly.
There is an easy and cheaply constructed portfolio which is close to optimal. It combines the highest rated government bonds in your currency with the most diversified possible world equity portfolio. Get close to that in the right proportions, which depend mainly on your risk tolerance, stick to it and in my view you are doing better than 95% of all investors. That’s it – two securities: one being an index tracker of world equities and the other a security that represent government bonds of maturity and currency that match your need. Both equity and bond exposure perhaps via an ETF. Simple perhaps, but you capture an incredible diversification of exposures via the equities and the portfolio is at your risk appetite when you incorporate the bonds in a proportion that suit your risk. You can add other government and diversified corporate bonds if you have appetite for a bit more complexity in your portfolio, but the portfolio is very powerful even without those.
Your specific circumstances do matter a great deal. Think hard about your risk appetite and optimizing your tax situation. But also pay attention to your non-investment assets and liabilities – many people already have a disproportionate exposure to their domestic economy through their house and some sector via their jobs. Don’t add to this concentration risk with your investment portfolio.
Be a huge stickler for costs, don’t trade a lot, and keep your investments for the very long run. The portfolio above should only be implemented via extremely cheap index tracking products that charge 0.25% per year or less.

Follow these steps and I think you will have a personal portfolio strategy that lets you sleep well at night, knowing that you have created a powerful and diversified portfolio cheaply, tailored to your risk appetite. To emphasize the point of costs, suppose you are a frugal saver who diligently put aside 10% of $50,000 annual income from the age of 25 to 67 that you invest in world equities. Further assume markets return 5% real per year in line with historical returns (ignoring taxes). Considering a typically 2% annual cost difference between an index tracking product and an actively managed fund (potentially in addition to the cost of an advisor), as you get ready to retire at age 67 the difference in the savings pot is staggering. You are left better off by perhaps $250,000 in today’s money simply by investing with an index fund as opposed to an active manager.

porsche_savings_from_low_cost_mutual_funds — Can index funds save you enough to afford this?

If you think you have great edge in the market and think you could easily make up this 2% annual cost difference then by all means pick an active manager or your own stocks. If not, then the sooner you shift out of the expensive investment products or active stock picking and into cheap index tracking products the better off you will be. To put things in perspective consider that these additional and unnecessary fees for just one saver over their investing lives could buy 6 Porsches. And paradoxically this is money paid to the finance industry from a saver who could typically not afford to drive a Porsche.

Lars Kroijer is the author of Investing Demystified – How to Invest Without Speculation and Sleepless Nights from Financial Times Publishing. He founded and ran Holte Capital, a London based hedge fund in 2002. You can follow him on Twitter @larskroijer.

Please also see related posts:

Agnosticism Over Edge Can Earn You 7 Porsches

Book Review of Investing Demystified

Podcast Part I – Lars Kroijer on Global Diversification

Postcast Part II – Lars Kroijer on Having Edge

Lars on CNBC discussing his book Money Mavericks

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February 17, 2014February 17, 2014

Interview: Lars Kroijer (Part II) – On Having An Edge In The Markets

Podcast: Play in new window | Download

Please see earlier podcast Interview with Lars Kroijer Part I – on the importance of Global Diversification

And my earlier book review of Lars Kroijer’s Investing Demystified.

In this discussion with author Lars Kroijer we talk about the main assumption of his book Investing Demystified – which I happen to completely endorse – which is that ‘beating the market’ lies somewhere between highly unlikely and impossible. The goal for individuals should be, instead, to earn market returns. Common behaviors that most investors do, like

1. Paying extra management fees to an active portfolio manager, or

2. Stock picking yourself in order to ‘beat the market’

is a fool’s game, and will ultimately prove unnecessarily costly.

Later in the interview I asked Kroijer to describe his earlier book, Money Mavericks.

Lars: Everyone’s got sort of their angle. My angle is really to start with asking a question of the investor, which is; do you have edge? Are you able to beat the markets? I don’t even make that call for you but I try to illustrate it is incredibly hard to have edge, and that most people have no shot in hell whatsoever of attaining it. Incidentally, that means that people like you are I are not necessarily hypocrites because it’s entirely consistent with our former lives to say we worked in the financial markets; we’ve bought and sold products, and as well informed as anyone. So if we didn’t have edge, edge doesn’t exist.

You could say I’m a hedge-fund manager, and I sold edge for a living, and I certainly thought I had it. But that doesn’t mean that most people, or even that many people have it. I start with the premise in this book of saying do you have it. Then I go on to explain it’s really bloody hard to have it. If you don’t have it, which most people don’t, what should you do?

Essentially, this is a book written for my mom. It kind of is. You wouldn’t believe, but as a former hedge-fund manager, every time I talk to my mom, who’s a retired schoolteacher, she’d always say which stock should I buy. I’d say mom, you could buy an index. And she’s like no, no. Then she’d say stuff like Dansker bonds have done so well, I should be buying it. And I’d be like no, don’t do that. She’s certainly not alone in that position.

Michael: I completely agree with you, and when I think about how your book lays out four simple rules, starting with the one that you should be exposed to the broadest, most global index portfolio, and I have not done that, in terms of I am US-centric and small-caps centric, so I don’t have the broadest exposure. On the other hand, there is no gap between what you advocate, in terms of can you beat the market, and the way in which I invest, which is always I assume from the get-go ‑‑ and this is why that part of it resonated with me ‑‑ so clearly I, like you, say you can’t beat the market. The goal should not be to beat the market. The goal is to expose yourself to the appropriate allocation to risky markets, appropriate to your own personal situation. And then get the market return.

Lars: You want to capture the equity-risk premium.

Michael: The entire finance-marketing machine is about can you beat the market. Beating the market is a complete fool’s game. I think it’s particularly interesting, the other reason I wanted to talk to you, is because you’ve worked in the hedge-fund world, you’ve been a hedge-fund manager, an advisor to hedge funds. I worked on Wall Street. I founded my own fund, and it’s all about that theory that you can, in a sense, have an edge in the market. Yet, the more you know about how it actually works, the more extremely bright people, with the highest powered computing power and the most cutting-edge ideas ‑‑ and you think about the power they had, and we had, and the chances of any retail investor or in fact any of those investors themselves beating the market, or as you say, having edge, is just impossible.

Lars: Add to that they’re at a huge cost disadvantage, informational disadvantage, analytical disadvantage. It’s so unlikely, and this is why always start with you’ve got to convince people they can’t. That’s actually probably the toughest thing. You’re fighting not only against conventional wisdom, but you’re also fighting this almost innate thing we have, that you somehow have to actively do something. You somehow have to pick Google or whatever.

You have to have a view, and you’re smart, you’re educated, doing something to improve your retirement income, or whatever you’re doing. What you and I are advocating is essentially do nothing. Admit you can’t. I think that rubs a lot of people the wrong way.

Michael: You need to bring humility to the situation. I cannot do better than the market. I can do the market but I can’t do better. It’s a very hard, humble approach, but in my opinion and in your opinion it’s the correct approach.

Lars: Yeah. And I also think we’re extremely guilty of selective memory. We remember our winners. That adds to the feeling. It’s a bit like when you ask guys whether they’re an above-average driver. 90% will say they’re above average.

If you ask stock pickers whether they do better than average, 90% of stock pickers would say yes, even more than that. I think there’s a lot of that, a huge degree of selective memory. It’s a shame because I think it really hurts people in the long run.

Michael: It makes conversations along the lines of what you mentioned with your mother conversations with me and other friends and retail investors in stocks ‑‑ hey, I’ve got this great new stock. I’m such a bummer when I talk to them because I say really? I don’t know what to say.

Lars: The alternative is to say you don’t know what you’re talking about, which is not an all together pleasant thing to say. It’s not how you make friends. Certainly not when you’re moving to a new town, like you did.

Michael: I’ve written about this on my site before, but essentially when somebody talks about individual stocks, to me what I’m hearing is I went to Vegas. I put money on 32 and 17 on the roulette wheel. Look how I did. I just don’t know how to respond to that. That’s fabulous, you hit 17 once. I don’t know what to say.

Lars: This is conventional wisdom because to most other people that person will sound smart and educated. They will say here’s why I found this brilliant stock and here’s why it’s going to do great. Most people in the room will consider that person really smart, educated, and someone who’s got it. They’ll sound clever about something we all care about, namely our savings. And you think if I could only have that, I’d want that. It’s tough to go against that.

This is why I think the biggest part of this book is if I could get people to question that. Maybe even accept they can’t beat the market. Then that would be the greatest accomplishment. I think a lot of the rest follows. I haven’t come up with any particularly brilliant theory here. It’s sort of academic theory implemented in the real world and that’s pretty straightforward.

Michael: It cuts against the grain of what I call on my site “Financial Infotainment Industrial Complex,” which is there’s a lot of people invested in the idea that markets can be beaten, that individual investors can play a role.

Lars: Think of how many people would lose their jobs?

Michael: Yeah, it’s an entire machine around this idea. It’s very hard to fight against that. It’s very boring to fight against that. I joked about it in my review; your book is purposefully hey, I have some boring news for you. Here’s the way to get the returns on the market and sleep better at night.

Lars: I sort of compared going to the dentist. You really ought to do it once in a while and think about it. I completely agree with you. I mentioned in the book ‑‑ when I thought about writing this book, it was one of these things that slowly took form, but there’s this ad up for one of these direct-trading platform websites. And there was a guy who was embraced by a very attractive, scantily dressed woman. He was wearing Top Gun sunglasses, with a fighter jet in the background. It said something like “Take control of your stock market picks.”

I thought fuck; are you kidding me? Really? Whoever falls for that, I’d love to sell them something.

Michael: Oh yeah, they’d be a great mark.

Lars: You also hear a lot about the quick trading sort of high-turnover platforms. It’s something like 85-90% of the people on there will lose money. You have a lot of these companies, their clients, 85-90% will lose money.

It’s almost akin to gambling. You can argue is it gambling, which is a regulated industry in a lot of countries, for good reason, because it costs you a lot of money. And I think certain parts of this circus is the same. But it’s very tough to regulate, and I’m not saying you should. But it could cost a lot of people a lot of money.

I feel very strongly about this. I’m not saying edge doesn’t exist. I’m saying it’s really hard to have it. And you’ve got to be clear in your head why you do, and what your edge is.

Michael: I have not read [Kroijer’s previous book] Money Mavericks but give me a preview so when I do read it, what am I going to get?

Lars: It’s a very different book. Money Mavericks is essentially the book of how someone with my background, a regular kid from Denmark ends up starting and running a hedge fund in London, and all the trials and tribulations, humiliations and all that you go through in that process. I thought when I wrote it lots of things have been written about hedge funds, and a lot of it’s wrong. Namely this whole idea that we’ll all drive Ferraris and date Playboy Bunnies and do lots of cocaine.

I thought very little was written from a first-hand perspective, someone who’s actually set up a fund and gone through the fund raising and trying to put together a team. And the humbling failures, and successes, so I thought let me try to write that. I did. I found myself enjoying the process of writing it, which I guess was part of the reason I did it. But then it got published, and it ended up doing really well.

I was actually kind of pleased about that because I thought it’s very nonsensationalist. We didn’t make billions, we didn’t lose billions. No one defrauded us and we didn’t defraud anyone. So those are the four things you normally think about when you think of hedge funds.

Michael: If you’re trying to sell books, yes.

Lars: Yeah, so this is none of that. It’s just a story of some guy starting a hedge fund, how it all worked out, all the little anecdotes. I was really pleased that resonated. In fact, the best feedback I got was from people in the industry who were like yeah, that’s exactly what it was like. I’m sure you would appreciate it because you’d have lived a lot of it. Begging for money.

Michael: No, that’s my second [imaginary] book. My first [imaginary] book is personal finance. My second book is gonna be that experience, your books in reverse.

Lars: I think you’d enjoy it. That resonates with a lot of people, including what you also would’ve experienced, this whole undertone of anyone can start a hedge fund; I’m going to quit my job and raise 50 million dollars. I’m going to build a track record and then raise another couple of hundred million. Then I’m going to be rich and happy. The number of times I’ve heard some version of that makes me want to puke. When you’re actually doing it you realize how incredibly hard it is.

Michael: Very stressful.

Lars: It impacts your health, your life, your family, all of that. Then that’s before you try to make or lose money.

Michael: You actually have to do it, get a return that people are happy with, and they’re happy to stick with you. Does your fund exist still?

Lars: No, it’s just my own money. I had incredibly fortuitous timing. I returned all capital in early ’08. But no skill, it was for mainly my own reasons, sanity, health, and family. I’ve been lucky.

Michael: As we always say better lucky than good. That’s more important.

Lars: For me there was a big part of that. I thought let’s quit while you’re ahead. To be honest, I have yet to wake up one day where I miss it. I get to wake up one morning where I wish I was heading to Mayfair to turn on to Bloomberg and be at it.

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Tag: investing demystified

Don’t Forget International Stocks

Guest Post: The Simplest Investment Approach, Ever

Interview: Lars Kroijer (Part II) – On Having An Edge In The Markets

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