Thanks for engaging on this. I’ve been having trouble making up my mind about international equities, which is delaying my plan to leverage up (while hedging due to current market conditions), and it really helps to have someone argue the other side to make sure I’m not missing something.
This is most obvious in the case of bonds—if 30-year bonds from A are yielding 2%/year and then fall to 1.5%/year over a decade, while 30-year bonds from B are yielding 2%/year and stay at 2%/year, then it will look like the bonds from A are performing about twice as well over the decade. But this is a very bad reason to invest in A. It’s anti-inductive not only because of EMH but for the very simple reason that return chasing leads you to buy high and sell low.
Assuming EMH, A’s yield would only have fallen if it has become less risky, so buying A isn’t actually bad, unless also buying B provides diversification benefits. Applying this to stocks, we can say that under EMH buying only US stocks has no downsides unless international equities provide diversification benefits, and since they have been highly correlated in recent decades (after about 1990) we lose very little by buying only US stocks.
Of course in the long run this high correlation between US and international equities can’t last forever, but it seems to change slowly enough over time that I can just diversify into international equities when it looks like they’ve started to decorrelate.
If I had to guess I’d bet that US markets are salient to investors in many countries and their recent outperformance has made many people overweight them, so that they will very slightly underperform. But I’d be super interested in good empirical evidence on this front too.
US stock is 35% owned by non-US investors as of 2018 and had been going up recently. Meantime non-US stock is probably >90% owned by non-US investors (not sure how to find the data directly, but US investors only have 10% international equities in their stock portfolio). My interpretation is that non-US investors are still under-weighing US stocks but have reduced their bias recently and this contributed to US outperformance, and the trend can continue for a while longer before petering out.
A lot of my thinking here comes from observing that people in places like China have much higher savings rates, but it’s a big hassle at best for them to invest in US stocks (due to anti-money laundering and tax laws) and many have just never even thought in that direction, so international investment opportunities have been exhausted to a greater degree than US ones, and the data seems consistent with this.
Let me know if the above convinces you to move in my direction. If not, I might move to a 4:1 ratio of US to international equities exposure instead of 9:1.
I personally just hold the market portfolio.
BTW while looking for data, I came across this article which seems relevant here, although I’m not totally sure their reasoning is correct. I’m confused about how to reason about “market portfolio” or “properly balanced portfolio” in a world with strong “home bias” and “controlling shareholders”.
But in Corporate Governance and the Home Bias (NBER Working Paper No. 8680), authors Lee Pinkowitz, Rene Stulz, and Rohan Williamson assert that at least some of the oft-noted tilt is not a bias at all but simply a reflection of the fact that a sizeable number of shares worldwide are not for sale to the average investor. They find that comparisons of U.S. portfolios to the world market for equities have failed to consider that the “controlling shareholders” who dominate many a foreign corporation do not make their substantial holdings available for normal trading.
Take this into account, the authors argue, and as much as half of the home bias disappears. A more accurate assessment of globally available shares, they say, would show that about 67 percent of a properly balanced U.S. portfolio would be invested in U.S. companies.
I’m surprised by (and suspicious of) the claim about so many more international shares being non-tradeable, but it would change my view.
I would guess the savings rate thing is relatively small compared to the fact that a much larger fraction of US GDP is inevestable in the stock market—the US is 20-25% of GDP, but the US is 40% of total stock market capitalization and I think US corporate profits are also ballpark 40% of all publicly traded corporate profits. So if everyone saved the same amount and invested in their home country, US equities would be too cheap.
I agree that under EMH the two bonds A and B are basically the same, so it’s neutral. But it’s a prima facie reason that A is going to perform worse (not a prima facie reason it will perform better) and it’s now pretty murky whether the market is going to err one way or the other.
I’m still pretty skeptical of US equities outperforming, but I’ll think about it more.
I haven’t thought about the diversification point that much. I don’t think that you can just use the empirical daily correlations for the purpose of estimating this, but maybe you can (until you observe them coming apart). It’s hard to see how you can be so uncertain about the relative performance of A and B, but still think they are virtually perfectly correlated (but again, that may just be a misleading intuition). I’m going to spend a bit of time with historical data to get a feel for this sometime and will postpone judgment until after doing that.
Thanks for engaging on this. I’ve been having trouble making up my mind about international equities, which is delaying my plan to leverage up (while hedging due to current market conditions), and it really helps to have someone argue the other side to make sure I’m not missing something.
Assuming EMH, A’s yield would only have fallen if it has become less risky, so buying A isn’t actually bad, unless also buying B provides diversification benefits. Applying this to stocks, we can say that under EMH buying only US stocks has no downsides unless international equities provide diversification benefits, and since they have been highly correlated in recent decades (after about 1990) we lose very little by buying only US stocks.
Of course in the long run this high correlation between US and international equities can’t last forever, but it seems to change slowly enough over time that I can just diversify into international equities when it looks like they’ve started to decorrelate.
US stock is 35% owned by non-US investors as of 2018 and had been going up recently. Meantime non-US stock is probably >90% owned by non-US investors (not sure how to find the data directly, but US investors only have 10% international equities in their stock portfolio). My interpretation is that non-US investors are still under-weighing US stocks but have reduced their bias recently and this contributed to US outperformance, and the trend can continue for a while longer before petering out.
A lot of my thinking here comes from observing that people in places like China have much higher savings rates, but it’s a big hassle at best for them to invest in US stocks (due to anti-money laundering and tax laws) and many have just never even thought in that direction, so international investment opportunities have been exhausted to a greater degree than US ones, and the data seems consistent with this.
Let me know if the above convinces you to move in my direction. If not, I might move to a 4:1 ratio of US to international equities exposure instead of 9:1.
BTW while looking for data, I came across this article which seems relevant here, although I’m not totally sure their reasoning is correct. I’m confused about how to reason about “market portfolio” or “properly balanced portfolio” in a world with strong “home bias” and “controlling shareholders”.
I’m surprised by (and suspicious of) the claim about so many more international shares being non-tradeable, but it would change my view.
I would guess the savings rate thing is relatively small compared to the fact that a much larger fraction of US GDP is inevestable in the stock market—the US is 20-25% of GDP, but the US is 40% of total stock market capitalization and I think US corporate profits are also ballpark 40% of all publicly traded corporate profits. So if everyone saved the same amount and invested in their home country, US equities would be too cheap.
I agree that under EMH the two bonds A and B are basically the same, so it’s neutral. But it’s a prima facie reason that A is going to perform worse (not a prima facie reason it will perform better) and it’s now pretty murky whether the market is going to err one way or the other.
I’m still pretty skeptical of US equities outperforming, but I’ll think about it more.
I haven’t thought about the diversification point that much. I don’t think that you can just use the empirical daily correlations for the purpose of estimating this, but maybe you can (until you observe them coming apart). It’s hard to see how you can be so uncertain about the relative performance of A and B, but still think they are virtually perfectly correlated (but again, that may just be a misleading intuition). I’m going to spend a bit of time with historical data to get a feel for this sometime and will postpone judgment until after doing that.