The mistake most U.S. investors are guilty of — and why making it today is more dangerous than ever

Today, we’re going to talk about an investing concept that doesn’t get discussed nearly enough.

That’s too bad, because if you act on this idea, it could result in major outperformance for your portfolio over the course of your investing career — or at least it will better protect the wealth you have today. And that’s no exaggeration. That statement is rooted in historical market data.

“Sounds great! Why haven’t we talked more about this?” you might be thinking.

Frankly, because it’s not sexy — and because the investment benefits of this idea play out over many years, rather than over the next few quarters.

You see, this idea is more of a “long-game” concept. It doesn’t get lots of air-time because it doesn’t offer overnight homerun potential. It’s not a hot tip on a surging biotech, or a new high-flying tech IPO, or maybe a crazy cryptocurrency that’s skyrocketing.

Those ideas are a bit like the star quarterback who gets all the glory and post-game interviews. But the idea today is more like the offensive linemen you never see on TV.

Of course, if a lineman didn’t do his job, that star quarterback would go down with a torn ACL and a concussion.

So, in today’s Digest, as non-flashy as it is, let’s do some blocking so that we can protect your portfolio from a concussion.

 

***Quick, without thinking, which one of your children is your favorite?

 

Yes, yes, you love them equally but in different ways …

Unfortunately, it doesn’t quite work that way in the investment world. We tend to have a very clear “favorite child” so to speak. And we give this child way too much attention.

I’m referencing an investment phenomenon called “home country bias.”

As the name implies, home country bias is the tendency for investors to allocate a majority of their wealth to investments from their own country.

It’s not a uniquely American phenomenon. It happens to investors all over the world.

Below is a chart from Vanguard that shows this home country bias at work. One of its inputs is a given country’s global index weight. In other words, if we looked at the entire world as one big investment market, how much “weight” should a specific country have within that global portfolio, based on its size?

Large stock markets like that of the U.S. would have a bigger “weight” of the global market portfolio than a smaller stock market, like the one in Australia.

The second variable in the chart below shows the percentage of domestic stocks that investors in each country hold in their portfolios. As you can see, all around the globe, investors put way more into domestic stocks than their own country’s weight deserves.

Notice how here in the U.S., we put nearly 80% of our investment dollars into the U.S. market! Of course, on a percentage basis, the Australians are way worse.

***”So what?” you ask, “U.S. stocks always outperform the rest of the world, so I should be investing more here at home anyway”

Are you sure about that?

My good friend, Meb Faber, is what we call a “quant” investor. Basically, he studies volumes of historical market data to create quantitative rules that tell him when and why to invest.

If the U.S. market always outperforms the rest of the world, Meb is the guy who could verify that given his expertise at historical market analysis. Unfortunately, that’s not what we find.

From a piece Meb wrote back in January:

As you can see below, as I write, the U.S. trades at a long-term CAPE ratio of around 29.

(Note: “CAPE” stands for “cyclically adjust price-to-earnings” ratio. It’s a long-term measure of a market’s valuation. And it’s actually higher now — 30.92 as I write.)

This level is fairly high from a historical perspective. For further context, the average CAPE from countries around the globe is roughly 16. That makes the U.S. level nearly double that of the average global country …

… if the U.S. market is so fantastic that a higher valuation is always warranted, then historically, it should always have a higher valuation.

But that’s not what history tells us.

Below is a chart showing the U.S.’s CAPE versus the world ex U.S. (i.e. foreign stocks). Going back to 1980, both have an average CAPE ratio of about 22. Let me repeat: the historical valuation premium has been ZERO.

Beyond that, the amount of time each spends being more expensive than the other is basically a coin flip. That stat surprises a lot of people who assume that the U.S., being currently expensive, ALWAYS trades at a premium and for some reason “deserves to”. (After all, the U.S. is special.)

 

 

***Meb isn’t the only respected investor who’s sounding the alarm on home country bias

You might recognize the name Bridgewater. Run by famous investor and billionaire, Ray Dalio, it’s one of the largest, most successful hedge funds in the world.

In February, Bridgewater released a study called “Geographic Diversification Can Be a Lifesaver, Yet Most Portfolios Are Highly Geographically Concentrated“.

From the paper:

In the past century, there have been many times when investors concentrated in one country saw their wealth wiped out by geopolitical upheavals, debt crises, monetary reforms, or the bursting of bubbles, while markets in other countries remained resilient.

Even without such extreme events, there is always a big divergence across the best and worst performing countries in any given period. And no one country consistently outperforms, as outperformance can lead to relative overvaluation and a subsequent reversal.

Rather than try to predict who the winner will be in any particular period, a geographically diversified portfolio creates a more consistent return stream that tends to do almost as well as whatever the best single country turns out to be at any point in time. So geographic diversification has big upside and little downside for investors.

If you’re still doubting that U.S. isn’t always the best, note the charts below from the Bridgewater piece. Look at how the U.S. market has spent plenty of time in the “middle of the pack,” so to speak.

 

***It’s important to note the correlation between valuation and future returns

So, let’s take this one step further.

We invest too much in our home countries … And historical analysis shows that no one country always outperforms …

So, the thinking investor would ask “is there a way to know when a specific country is going to do well, versus poorly?”

It turns out, there’s a blunt tool we can use. It’s not a perfect timing tool, but it’s still incredibly helpful. Think of it as a sledgehammer, rather than a chisel.

We referenced it earlier — it’s called the CAPE ratio.

We don’t have the space to dig into all its details in this Digest, but the overall takeaway is this:

Markets tend to revert to the mean over time. So, a country that has a high CAPE value today is more likely than not to see its value fall in the coming years. That would mean below-average stock returns.

On the flip side, a country that has a low CAPE value today is more likely than not to see its value rise in coming years. And that would be based on above-average returns.

The more extreme the starting CAPE value (either high or low), the more pronounced those 10-year returns often are.

Want a visual representation of this, using real market data?

Below is a chart from Meb. Starting in 1900, the chart shows initial CAPE values and what the 10-year returns ended up being based on those starting CAPE values.

Dark green represents the cheapest CAPE starting years. Red represents the most expensive.

As you’ll see visually, most of the “green” starting years (low CAPE ratios) end up on the right side of the chart — meaning big 10-year returns.

On the flip side, “red” starting years (high CAPE ratios) usually end up on the left side of the chart — meaning low and negative 10-year returns.

It doesn’t always work this way — but it works enough to be incredibly helpful to a long-term investor. Remember, we’re talking sledge hammer, not a chisel.

 

***So, how are you invested today?

 

First, if you look at your portfolio, how much of it is invested right here in the U.S.?

50%? 75%? All of it? To what extent are you guilty of home country bias?

If the answer is “really guilty,” then let me draw your attention back to what the current CAPE valuation is here in the U.S. — nearly 31.

In the chart above, that puts us firmly in those “red” starting years. And as you can see, that doesn’t bode well for 10-year returns.

Now this doesn’t mean that U.S. stocks are going to tank tomorrow. In fact, this bull market could have many more months of gains left in it.

It also doesn’t mean that certain narrower, thematic U.S. investments (for instance, legalized marijuana and 5G/batteries) aren’t going to enjoy mind-boggling gains for many years to come. But what this does mean is that if most of your investment wealth is tied to your typical, bread-and-butter U.S. stocks and funds, then you’re taking more risk than is wise.

 

***Wrapping up, this isn’t a flashy topic …

 

… but it’s an incredibly important one.

Here at InvestorPlace, our allegiance isn’t limited to helping you find home-run stocks, it’s also to helping you protect the wealth you have today.

So, while you’re out there looking for that next high-flying quarterback investment, remember that games are won based on a great teamperformance — and that includes a solid effort from all those linemen. If you haven’t analyzed your portfolio with this idea in mind, perhaps it’s time.

Have a good evening,

Jeff Remsburg