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If you’re a U.S. investor, there are at least two biases that feature prominently in your portfolio:
1) Home bias: the tendency for individuals and institutions in most countries to hold only modest amounts of foreign equity.
2) Recency bias: the tendency to think that trends and patterns we observe in the recent past well continue in the future.
While these biases can exist in any time period, they are probably more pronounced today than most other periods in history. Why?
Because U.S. equities have, to put it mildly, been trouncing their global peers.
Over the past five years (through January 2016), the S&P 500 advanced 105% (15.4% annualized) versus a gain of only 27% (4.9% annualized) for the MSCI World (ex-US).
Remarkably, this differential in performance, while at the higher end of the historical range, is not unprecedented. We saw similar to greater outperformance from U.S. equities in the mid-1980s and mid-to-late 1990s. [Note: both periods were followed by international outperformance.]
The temptation after such periods is to abandon all foreign equity exposure and only hold U.S. stocks. After all, “diversification” outside of the U.S. has only hurt you over the past 5+ years. And indeed, if you listen to most pundits in early 2016, they will tell you this trend is likely to continue with statements like “the U.S. economy is faring much better than the global economy” and the “U.S. is the best house in a bad neighborhood.”
The problem, of course, is such analysis is backward looking. Pundits are the worst offenders when it comes to recency bias, reporting the past as if it were an effective investment strategy.
More discerning investors will ignore these pundits and note that there have been wide swings in performance between the U.S. and international stocks. Sometimes the U.S. leads and other times international stocks lead. Since 1970, the S&P 500 has outperformed the MSCI World (ex-US) in 54% of calendar years. While this is little better than a coin flip, what’s fresh in the minds of investors is the negative returns from international equities in 2014 and 2015 while U.S. stocks closed higher.
Overall, since 1970, U.S. stocks have returned 10.1% (annualized) versus 7.5% for international stocks. Some would view this wide disparity in performance as a reason to only hold U.S. stocks (why take the risk of buying foreign equities if they have a lower overall returns?). If you believe the future equals the past than this analysis is correct. If you do not subscribe to this notion, though, an alternative viewpoint is warranted. The 260 bps of annualized underperformance likely means that international equities are unloved and cheaper than their U.S. counterparts with mean reversion to favor looking abroad in the years to come.
I don’t know what will happen in the next few months or the remainder of 2016. No one does. U.S. stocks could very well continue to outperform. But given that we cannot predict the future, diversification into international equities here protects investors from the possibility that U.S. stocks don’t continue to trounce their global peers tomorrow. This is especially true if you currently hold no non-U.S. equity exposure.
History has taught us that the best time to diversify into an asset class is after an extreme period of underperformance, not outperformance. If past is prologue, then, U.S. investors may do better in the coming years by looking abroad. While this sounds simple in theory, overcoming both home bias and recency bias is not an easy task. Only those investors that can control these behavioral biases will reap the rewards.
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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
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