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Your portfolio may be less diversified than you think

Key Points
  • Investors tend to hold mostly domestic stocks—even when their country is the home of only a small portion of the world’s stock market.

  • The stock markets of many major countries have performed like a single sector of the world stock market making a portfolio with a large home bias lack broad diversification—even for those investors that live in the United States.

  • Diversification can help lower portfolio volatility and ensure you always have some exposure to whatever sector is performing the best, but can also seem to be a drag on portfolio performance when one sector sharply outperforms the others for an extended period.

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, as well. Investors tend to hold mostly domestic stocks—even when their country is the home of only a small portion of the world’s stock market, as you can see in the chart below.

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

Source: Charles Schwab, International Monetary Fund Coordinated Portfolio Investment Survey, Factset, data as of 8/11/2016.

U.S.-based investors seem to believe they are sufficiently diversified with about 75% of their equity investments inside their country’s borders, as do those that live in Japan or Spain or dozens of other countries—even Brazil and South Korea. These investors with a large home bias may not be nearly as diversified as they believe.

Single-Sector Stock Markets

No one country offers full global stock market exposure. In fact, it may be surprising how closely some major countries stock markets perform like a single sector of the global stock market. This illustrates the lack of diversification inherent in having a portfolio with a large home bias, even for those investors that live in a major country. Three major single-sector stock markets include Canada, Japan and the United States.

  • The entire Canadian stock market performs much like the energy sector. As you can see in the chart below, the Canadian stock market has performed like the MSCI World Energy Index. In fact, it has actually performed similar to 1.3 times the moves in that index. This is despite the fact that energy isn’t even the biggest sector of Canada’s stock market; the energy sector makes up only 22% of the market value of the stocks in the MSCI Canada Index. The Canadian economy is more reliant than most on natural resources, where even the banks are tied to the commodity cycle. Canadian investors’ home bias, evident by the greater than 50% of their stock portfolios invested in their domestic stock market, makes sense only if Canadians think exposure to the energy sector should make up more than 50% of their portfolio.

Canada’s stock market behaves like the energy sector

Indexes measure cumulative total return in US dollars since start of 1999.
Source: Charles Schwab, MSCI data as of 8/11/2016.

  • In Japan, the stock market closely tracks the global financial sector. As you can see below, the Japanese stock market has performed similarly to 0.6 times the MSCI World Financials Index. The financial sector is not the largest in Japan’s stock market (the consumer discretionary sector is the largest, which includes globally-recognized companies like Toyota and Sony), but the influence of global financial conditions on all types of Japanese companies is evident in their performance. Rather than being broadly diversified, Japanese investor’s home bias means they have about 75% of their portfolios linked to the moves in the global financial sector.

Japan’s stock market behaves like the financial sector

Indexes measure cumulative total return in US dollars since start of 2006.
Source: Charles Schwab, MSCI data as of 8/11/2016.

  • In the United States, the largest sector of the stock market seems to drive overall performance. As you can see in the chart below, the U.S. stock market has performed similarly to 0.9 times the MSCI World Information Technology Index. Notice that the performance of the U.S. stock market has not differed as much as Canada and Japan have from the global stock market, as measured by the MSCI World Index. That is because about half of the MSCI World Index is composed of U.S.-based companies. It is especially striking that even with that much overlap, the U.S. stock market still moves much more in sync with the information technology sector than with the more broadly diversified global stock market.

The U.S. stock market behaves like the information technology sector

Indexes measure cumulative total return in US dollars since start of 2006.
Source: Charles Schwab, MSCI data as of 8/11/2016.

Sectors tell the story

Clearly, sector exposures go a long way to explain the differences in performance by country—regardless of politics or economics. Of the three stock markets discussed above, the United States has performed the best (+104%) as it tracked the run up in the world information technology sector (+127%) over the past 10 years ending July 2016. The United States was followed by Canada (44%), fueled by the world energy sector (25%). Japan was the weakest (10%), held back by the poor performance of the world financials sector (-7%).

To be well diversified, an investor should have exposure to many different sectors of the stock market. Broad global exposure is needed to achieve this, as even a portfolio that holds Canadian, Japanese, and U.S. stocks may behave as if it only had exposure to three stock market sectors (energy, financials, and information technology) rather than being more fully diversified across all ten.

Diversification can help lower portfolio volatility and ensure you always have some exposure to whatever sector is performing the best. Understandably, diversification can also seem to be a drag on portfolio performance when one sector sharply outperforms the others for an extended period.

Closely correlated

Stocks correlate more closely with others in the same sector across borders than they do with stocks in other sectors in their home country. This was not always true, but increasing globalization has firmly entrenched it over the past 10 years. This has started to prompt investors to reconsider the large home bias in their portfolios.

The global financial crisis of 2008-09 provided clear evidence of how tied together the performance of companies across borders can be in the financial sector, but we can find similar evidence in every other sector. Very different from the intangible output of companies in the financials sector, those companies in the consumer staples sector produce essential goods such as food, beverages, tobacco and household items, yet their performance is just as linked across borders as those of financials sector companies.

For example, in Japan, while the overall stock market tends to move in sync with financials, the Japanese stocks in each sector still tend to move in sync with their global peers. For example, Japanese consumer staples sector companies perform much like consumer staples companies headquartered in other countries, as you can see in the chart below.

Japan consumer staples stocks behave more like others in their sector than Japanese stocks

Indexes measure cumulative total return in US dollars since start of 2010.
Source: Charles Schwab, Factset data as of 8/11/2016.

While it is true that domestic stocks of developed countries tend to move in sync with their international peers in the same sector, that doesn’t mean domestic stocks always offer the best opportunity or best value to justify a large home bias.

Countries still matter

All this is not to suggest that the country a company is based in doesn’t matter, it does. But it matters to all the companies in the same sector that sell or produce in that country and not just the ones headquartered there.

The larger and more diverse emerging markets, such as South Korea, behave similarly to developed market countries where sector exposure defines performance more than country. However, among many emerging markets the country a company is based in remains more important than its sector in shaping performance.

Shedding home bias

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 simply by significantly boosting the international portion of their stock portfolios. For greater insight, see The Case for a Global Perspective.

Next Steps

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Important Disclosures

(0816-KUKN)

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