- The reason to diversify internationally is not because expected returns are higher on foreign* investments, but because they will be different. Diversification is about risk reduction, not return enhancement.
- Hedging currency risk is optional in equities but essential in fixed income.
- The belief that foreign holdings are unnecessary because domestic companies have large foreign sales, operations, subsidiaries, etc. is a canard. You could also only invest in every other stock in the S&P 500 – but why?
- In (academic) theory portfolios should be market cap weighted (currently 54% US, 34% foreign developed, and 12% emerging markets).
- Reasons for US investors to hold less than market cap weights in foreign stocks:
- Diminishing marginal benefit from diversification – the biggest “bang for the (diversification) buck” is from the initial exposures
- Maximizing happiness (i.e. minimizing tracking error) – US investors are typically “benchmarking” off of the S&P 500 (or off of people who are doing so)
- Hedging – competitors for (retirement) resources are generally overweight domestic equities
- Reasons for US investors to hold more than market cap weights in foreign stocks:
- Other exposures (real estate, human capital, pensions, SS, etc.) are generally domestic
- In our experience, knowledgeable and prudent portfolio managers typically allocate 20-30% of the equity portion of a portfolio to foreign equities.
- Our foreign allocation is 25% of investment grade fixed income and 25% of equities (20% of “risky”) but with a more concentrated dosage than typical in the equity positions.
*The investment industry for some inexplicable reason uses the term “international” to mean “foreign” and are then are forced to use “global” to mean “international.” I will use “foreign” when I mean “foreign.”