Global Diversification
Rational > Patriotic
For any disciplined investment approach to outperform over the long run, it must experience periods of underperformance in the short run.
Morgan Housel once wrote about the three distinct sides of risk:
The odds you will get hit.
The average consequences of getting hit.
The tail-end consequences of getting hit.
The first two are easy to grasp. It’s the third that’s hardest to learn and can often only be learned through experience. Say you are not wearing your seat belt – The odds that you will be caught are low (1), and even if you are caught, the fine you end up paying is not too much (2). But, the tail-end risk of getting into an accident while you are not wearing a seat belt (3), is all that should matter even though it has an extremely low probability.
A risk that we often overlook in investing is the country-risk. Most investors only invest in the country they are situated in — a well-known phenomenon called the Home Country Bias.
The U.S. stock market constitutes about 60% of the global market but on average U.S. investors allocate 80% of their portfolio to U.S. companies. The proportion is even more skewed in the case of smaller countries such as Canada and Australia. Canadians allocate ~60% of their portfolio to the Canadian market while it only constitutes 3% of the global market.
Investors irrationally expect higher returns in their domestic market compared to other markets. Expecting your country to outperform all other markets is definitely patriotic but it sure isn’t rational.
Ray Dalio did this fascinating thought experiment in his book The Changing World Order. Imagine if you went back in time to 1900 without any knowledge about the present and you want to invest your savings. The rational way of doing it would be to look at the top 10 greatest powers in 1900 and then invest in those countries.
Virtually any one of these countries was or could have become a great, wealthy empire, and they were all reasonable places for one to invest, especially if one wanted to have a diversified portfolio.
Seven of these 10 countries saw wealth virtually wiped out at least once, and even the countries that didn’t see wealth wiped out had a handful of terrible decades for asset returns that virtually destroyed them financially. — Ray Dalio
We would have never known about these crashes if we had just backtested the past few decades. The U.S. market has undoubtedly outperformed the world market over the past decade or so.
Many investors look at these numbers and wonder: What’s the point of owning any international stocks if U.S. counterparts are outperforming now?
This is a classic mistake known as fighting the last war. It’s where you believe in and use a strategy that has been successful in the past but is no longer a relevant tactic in the present. While the U.S. market has certainly outperformed in the past few decades, if history is any guide, it’s only a matter of time before the tide changes.