When you watch the Winter Olympic Games, it’s natural for you to think that the competitors from the U.S.A. are among the best in the world.
So even when your favorite American ski racer is sitting in 17th place after two rounds, you still hold onto the possibility that he could have a miraculous final run and win the gold. After all, he seems like such a nice kid from Colorado.
This natural favoritism is called “home bias.” And while it’s appropriate for watching sports, it can be detrimental to your investing strategy.
The recent stock market volatility has again shown why it’s so important to ignore this bias which predisposes us to be overly in favor of domestic stocks. Maintaining broad diversification based on math, statistics and research is the disciplined approach to overcoming natural biases.
Mitigating Short-Term Losses
Even though focusing on short-term market noise has little value for long-term investors, the data can help illustrate why diversification is so important. After analyzing data from early February’s wild swings, Dan Lefkovitz has found that those investors diversified into international, multi-asset-class funds experienced milder losses when the market dropped.
Writing for Morningstar U.K., he says, “Recent days have reinforced the benefits of multi-asset investing, diversification among stocks, bonds and beyond.”
So the numbers show that internationally diversified portfolios had fewer losses in the short-term. But aren’t we supposed to be thinking long-term? How do globally balanced portfolios perform over a longer time frame?
Analyzing Global Diversification As A Long-Term Strategy
According to Luis Viceira, Harvard Business School Dean for International Development, global diversification is still a prudent strategy for the long term. Since markets in foreign countries have recently experienced periods where they moving in tandem with the U.S., some so-called experts are suggesting a globally- diverse strategy is less worthwhile than it used to be. Viceira decided to investigate that claim using a broader data set.
Using 25 years of international market data, Viceira and his research team found that while markets around the world have been more likely to correlate, the linkage can be attributed to an alignment in investor sentiment and not the underlying fundamentals. Attitudes are a short-term phenomenon while market trends are not.
In other words, the global economy is still very diverse and an investment plan that takes advantage of this diversity still makes the most statistical sense.
“In fact,” says Viceira, “not diversifying can hurt those investors (who follow their home bias) by causing them to miss the more dynamic part of the economy if they get stuck in one country that is stagnating.”
Ultimately, the free flow of capital is a benefit to all economies. So U.S. companies can benefit from investing in foreign markets and vice-versa. Trying to predict in advance which country or region will do better than another is an unnecessary risk with low-probability return.
Stock price randomness and unpredictability are true wherever they’re freely traded. Pursing equity premiums everywhere they’re likely to exist over time makes sense because, home or abroad, stock prices are the best reflection of all known information in the short term and tend to outpace inflation in the long run.
To understand better how your investment plan is taking full advantage of the global economy, talk with us: 949-600-6060