Here’s a quick quiz for retirement investors everywhere.
It’s simple, consists of one question only, and the answer is straightforward
as well.
Oh, and the answer matters — big time.
The question: Based on the performance data of the last 50
years, what are the rough odds that the U.S. stock market will perform better
than non-U. S. stock markets over the next 12 months?
Are they:
A. 80%
B. 60%
C. 50%
Any clue?
The answer, using data from stock market financial data
company MSCI, is C: About 50%. Since 1970, when MSCI first began tracking the
numbers, the MSCI US stock market index has beaten the MSCI “ex-U. S.” index
(i.e., everywhere else) 51% of the time: 26 out of 51 years.
And, obviously, the rest of the world index has beaten the
U.S. the other 25 times.
(If 2020 carries on as it has so far, the U.S. figure will
rise to 27 out of 52, or 52%.)
There are less data about emerging markets but the results
are similar: Since MSCI began tracking EMs in 1987, the U.S. has done better in
17 years and emerging markets better in 15, or 53% of the time.
Given those odds, you’d assume the average investor holds
about half of their stock portfolio in non-U. S. stocks, right?
Sounds logical.
Oops.
To see how far removed the average investor is from this
simple allocation, look no further than the latest annual survey from
investment giant Vanguard. As it does every year, Vanguard opens the books on
its vast book of 5 million retail clients, showing how, on average, they
invest. It may be the best single overview of the typical Main Street U.S.
investor.
Among the various details, one thing sticks out like a sore
thumb: What’s known as “home country bias.” That means the psychological bias
among investors to keep most of their money in their national stock market.
The average U.S. stock portfolio is not 50% in U.S. stocks.
Nor is it even 60%, which is very roughly what current market values would
imply. It’s 81%. No, really.
The typical investor is keeping four-fifths of his or her
stock market portfolio in U.S. stocks. And that figure is pretty constant from
small investors to large: From those with investment accounts between $3,000
and $10,000 to those with more than $500,000.
It’s irrational. It’s so irrational that financial
economists have a name for it, “the home equity puzzle,” and have been trying
to explain it rationally for 30 years. “The home bias in equities has
fascinated both financial economists and international macroeconomists” since
at least the early 1990s, notes Kavous Ardalan, a professor of finance at Marist
College, in a recent review of the topic. This home country bias runs against
one of the central tenets of modern investment best practice: That you should
hold as diversified a portfolio as possible.
Experts have offered various ideas, but none fully explain
the bias. (Notably, the bias is the same overseas as well — residents of
foreign countries invest most of their money in that country’s market.)
Haim Levy at Hebrew University in Jerusalem offers a simple
explanation: Peer effect, also known as “Keeping Up With The Joneses.” When it
comes down to it, we “benchmark” our performance against the people around us.
So our biggest worry isn’t missing out on gains, but missing out on gains that
our neighbors are making. (Presumably we don’t mind missing out on profits so
much either, so long as our neighbors miss out on them.)
A truly diversified global fund such as the iShares MSCI
ACWI exchange-traded fund [ACWI], which tracks the All Country World Index
(including developed and emerging markets), still holds 58% of its money in U.S.
stocks. It really makes no logical sense to invest any more than that.
Personally, I tend to invest even more internationally than
that. There are powerful arguments that international and emerging markets
offer much better value than the U.S., especially after about 12 years’ of U.S.
outperformance. If I were going away to a desert island for five years, and had
to set an asset allocation before I went, I’d put a third each in the U.S.,
international developed markets and emerging markets, and hope for the best.
But at the very minimum I’d go with history and bet 50/50.
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