Investing Where It's Uncomfortable

It has long been said that one of the free lunches the market provides is that of diversification.  While true, it only exists for those willing to take advantage of the opportunity to spread their investments across a variety of asset classes, which may induce some anxiety as investors step outside of their comfort zones.

Part of this anxiety is due to the familiarity bias to which individuals succumb.  Many choose to invest the lion’s share of their assets in their home country.  While that might be appropriate for U.S. investors due to our large and diversified economy, it makes less sense for Norwegians for instance, where oil, fishing and timber industries might result in a portfolio dominated by natural resources. 

While diversification ensures that you’ll never end up at the bottom of the pack, it also ensures that you’ll never own more than just a piece of what’s working well.  However, you’ll always own a piece of what’s working well – and that’s the key.  Not every part of your portfolio should make you feel warm and fuzzy.  Oftentimes the best performing asset classes were those that did the worst the year before, as illustrated in the chart below.

This would suggest that international assets should be on the radar of long-term investors.  In fact, with the composite Eurozone purchasing manager’s index surging to a 71-month high and solid employment growth, it’s no surprise that Europe appears to be on the precipice of emerging out of a deflationary funk.  Markets are confirming that – the euro is strengthening versus the dollar, and international markets are outperforming the U.S. year to date.  Partly, this is due to improving fundamentals, but it also has much to do with more attractive valuations.  For example, the discount that Eurozone stocks trade to U.S. stocks on a price-to-book basis has widened to a 47% discount, offering room for outsized relative performance gains over time as that gap narrows back to its historical range.

And despite all the gloomy headlines about politics, it’s important to recall that the companies domiciled within a given country can be very immune to that country’s possible economic woes if they generate enough business overseas.  After all, Nestle only generates 2% of sales in Switzerland, and L’Oreal does less than a third of its business in Western Europe. 

Even if these political concerns might translate into less attractive business prospects, much of this appears priced in.  Even after his year’s double-digit rally, emerging markets – which account for 35-40% of global GDP – are currently trading at cyclically adjusted P/E ratios of 12X, compared with 28X in the US.  The story is similar in Europe, with the relative P/E of the euro area to the US at one standard deviation below its long-term average. 

As of February 2017, according to Dimensional Funds, the global market consisted of 53% US stocks, 36% international, and 11% emerging markets.  So even an investor with a balanced portfolio should consider a dollop of global stocks in their portfolios, not only to capture those attractive diversification benefits – but to participate in any potential valuation re-rating that might occur in the future.

It's important to become more comfortable with the prospect of investing abroad.  Remember, if you feel like bragging, it might be time to consider selling.  If you feel nervous, if might be time to consider buying.  Unlike in other areas of our lives, usually our gut emotions betray us a timing signal when it comes to investing.  On the path to earning higher returns, it’s quite normal to feel a bit uneasy about part of your portfolio, particularly if it hasn’t worked out as well lately.  But the nice thing with diversification across asset classes, is that unlike individual stocks, asset classes never go out of business!

Mike Giefer