Your Portfolio May Be Less Diversified Than You Think

Key Points

  • Investors with a large home bias may not be nearly as diversified across sectors as they believe and risk missing their financial goals as longer-term trends tend to shift with the start of a new global economic cycle.

  • Consider rebalancing portfolios back toward international stocks; years of U.S. stock outperformance may have caused a drift away from longer-term asset allocation targets.

  • Fortunately, obtaining global diversification has never been easier or less expensive.

When investors talk about “the stock market” they are most often referring to an index that tracks stocks only in their home country. This “home bias” is evident when it comes to the make-up of investors’ stock portfolios. Investors around the world tend to hold mostly domestic stocks. U.S. investors, for example, tend to put 75% of their equity holdings in domestic stocks, much higher than the 55% of global market capitalization composed of U.S. stocks. Those American investors with holdings based solely in the U.S. are missing out on about half the world’s investable universe.

Home bias: Investors’ portfolios overweight their home country no matter where they live 

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Source: Charles Schwab, IMF, CEIC, World Bank as of 9/21/2020

Investors with a large home bias may not be nearly as diversified across sectors as they believe and risk missing their financial goals as longer-term trends tend to shift with the start of a new global economic cycle.

Click here to listen to a Financial Decoder podcast where I explore home bias with Mark Riepe, head of the Schwab Center for Financial Research.

Sector surprise

No one country offers full global stock market exposure across all sectors. It may be surprising to know how closely some major countries stock markets perform like a single sector of the global stock market, illustrating the lack of diversification inherent in having a portfolio with a large home bias.

For example, despite the fact that only 12% of the value of the stocks in the MSCI World Automobiles Index are German, the German stock market closely tracked the performance of auto stocks for the past two decades. 

Germany driven by autos

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Source: Charles Schwab, Bloomberg data as of 1/29/21. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

There are plenty of other examples of the lack of diversification among major markets:

  • The Canadian stock market performs much like the energy sector. The Canadian economy is more reliant than most on natural resources, where even the banks are tied to the commodity cycle. 
  • In Japan, the stock market closely tracks the global financial sector. Even though the financial sector is not the largest in Japan’s stock market, the influence of global financial conditions on all types of Japanese companies is evident in their performance. 
  • In the United States, the largest sector of the stock market, technology, seems to drive overall performance. Overall, the U.S. acts a lot like one big tech fund.

This goes a long way to explain the differences in stock market performance by country—regardless of politics or economics. The United States has performed the best over the past 10 years as it tracked the run up in the world information technology sector. The United States was followed by Japan, fueled by the world financial sector which posted similar modest gains. Canada was the weakest, held back by the poor performance of the world energy sector which also posted a loss over the past 10 years. This was the reverse of the prior 10-year period in the early 2000s when Energy and Canadian stocks led the world’s markets as oil prices soared.

Countries and sectors

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Annualized price performance for 10 year period ending 12/31/20.
U.S. = MSCI USA Index, Technology = MSCI World Information Technology Index, Japan = MSCI Japan Index, Financials = MSCI World Financials Index, Canada = MSCI Canada Index, Energy = MSCI World Energy Index
Source: Charles Schwab, Bloomberg data as of 1/27/21. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.  Past performance is no guarantee of future results.

Global diversification can help ensure that you always have some exposure to whatever sector is performing the best.

Dollar direction

If you hold a stock that is denominated in another currency, you not only experience the change in the stock price in that currency but also the change in the value of the currency, when measuring your portfolio in dollars. The currency can move as much as the stock price---so it’s an important factor to consider. The U.S. dollar is the world’s most used currency, but that doesn’t mean its value is stable.

When the dollar falls, it can be a good thing for U.S.-based investors in international stocks. Here is an example: in July 2020, European stocks fell -1.5%, as measured in euros. But, because the U.S. dollar fell versus the euro by 4.8%, European stocks posted a gain of +3.3%, measured in U.S. dollars. That’s a big difference. If the dollar embarks on a long-term slide, it could act as a consistent boost to the performance of international stocks, as measured in U.S. dollars.

Currency contribution

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July 2020 price change of MSCI Europe Index and EUR-USD exchange rate.  For illustrative purposes only.
Source: Charles Schwab, Bloomberg data as of 1/27/21.

New cycle, new leadership

Market leadership tends to last for many years, even a decade before reversing. It usually switches between U.S. and international stocks at the start of a new cycle. For example, after international stocks outperformed in the 1980s, the 1990 recession saw a shift to US outperformance, then the 2001 recession saw a switch back to international outperformance, then the 2008 recession flipped the switch again to US outperformance. And now, the start of a new cycle may once again signal a switch to international stocks. 

Annualized performance by economic cycle

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Dates reflect economic cycle peaks defined by the National Bureau of Economic Research. Annualized total return between cycle peaks measured by MSCI USA Index and MSCI EAFE Index. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.
Source: Charles Schwab, Bloomberg data as of 12/31/20. Past performance is no guarantee of future results.

These changes in leadership result from behavioral as well as fundamental factors. Essentially, after a full cycle of outperformance, relative valuations and earnings expectations become stretched and begin to reverse with the catalyst of a new cycle. These factors have aligned once again. 

For more on the new market leadership check out our 2021 Global Outlook.

Global investing

The benefit of a broad international mutual fund or ETF is that you get exposure to a lot of sectors and stocks, rather than having to select individual securities for a portfolio. Fortunately, as many investors around the world consider reducing their home bias, obtaining global diversification has never been easier or less expensive. 

How much exposure outside your home country should you have in your portfolio? That depends on your risk tolerance and time horizon. It is clear from the data that most investors can broaden their opportunity set and diversify their portfolios by simply boosting the international portion of their stock portfolios. Now may be a good time to consider rebalancing portfolios back toward international stocks after years of U.S. stock outperformance may have caused a drift away from longer-term targets.

Next Steps

Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.

 Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

 Investing involves risk including loss of principal. International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets.  Investing in emerging markets may accentuate these risks.

Currencies are speculative, very volatile and are not suitable for all investors.      

Rebalancing a portfolio cannot ensure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. For additional information, please see schwab.com/indexdefinitions.

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