One of the most documented behavioral anomalies that afflict investors is their preference for the domestic stock market, ignoring the benefits that a portfolio of international stocks can offer in terms of diversification.
But beyond the benefits of “statistical” sort, there are factual reasons to avoid this bias. Not only does a broader investment universe increase the opportunities to participate in the success of innovative companies, it also helps to escape from the gravity of the local monetary system, something that can be decisive when your currency depreciates significantly (something that British investors can painfully testify)
On the other hand, there are compelling reasons that support home bias, from informational barriers derived from different legal and accounting systems, to a chauvinist preference for local companies that, in addition, usually confer tax advantages, and result in lower transaction costs for local investors.
However, a more profound dynamic that calls into question the advisability of blindly following the theoretical benefits of diversification seems to be revealing itself. It is a question about the divergent fates experienced by the core and the periphery of the capitalist system.
Do not tell a US investor to diversify into European or Japanese stocks, because he will laugh at you. We Europeans tend to think that this reflects a certain provincialism –here inevitably parallels will arise with the number of Americans who own a passport –, but the truth is that, like it or not, the US stock market has consistently outperformed most others during the last decades.
Furthermore, since the US market represents approximately half of the global stock market capitalization, the opportunity cost derived from the domestic bias is much lower for an American investor than for a European one; therefore, in reality we are “forced” to be more curious about what is happening in the USA than vice versa.
The US market is not only the core in terms of size, liquidity and transparency, but also features some of the most innovative and fastest growing companies in the world; and the gap is widening. It is as if the growing social inequality had also reached the corporate world.
The theory of international finance says that when capital flows from one country to another, it depresses the return on capital in the receiving country and increases it in the departing one. Or translated into stock markets, host country companies will be in high demand and, therefore, its valuation will be high, while those of the sending country will become cheaper. This “mechanical” way of thinking makes sense from a static perspective, but it is misleading if we consider that stock markets are an evolving entity.
Statistically speaking, there are good reasons why corporate success is not distributed evenly across all geographies. Local firms in the US enjoy the advantage of having the largest domestic market in the world as well as the largest government budget. They also have access to the largest talent pool thanks to counting with some of the best universities and a system that unapologetically rewards individual success. And as if all this was not enough, foreign start-ups relocate to the US in order to tap the largest venture capital pool in the world.
If at this point you have not yet lost faith in diversification, wait until you hear the funniest statistical fact; the most notable exception to the US rule is offered by Norway, a small country whose stock market is massively concentrated around a handful of “old economy” industries, such as fishing, oil exploration, shipping and forestry.
To conclude, my takeaway for next year’s asset allocation is to avoid being lured (once again) by the “valuation-gap trap” in European and Japanese stocks, and instead add a good dose of US tech companies, as well as Norwegian salmon producers. I will call this approach: the “Fish & Chips” portfolio.
Fernando de Frutos, MWM Chief Investment Officer
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