Note: This post was first published in January 2020 and updated in April 2021.
At some point, all stock market investors face the following question:
What is the right portfolio allocation between US and international equities?
As the data below shows, at the turn of the 20th century, the US stock market represented ~15% of the world’s total.
Fast forward a hundred or so years and the relative share has grown to ~52%.
And judging by the way the S&P has knocked it out of the park over the past decade (pandemics be damned!), I’d suspect the relative share is even higher today.
If you were to build a truly diversified global portfolio, you’d want it balanced according to the percentages in the second chart above.
However, there is strong empirical evidence that investors tend to hold an outsized proportion of domestic stocks in their portfolios.
In the investing world, it is known as home equity bias. Have a look at the chart below:
Think about it: if you live in Canada, it simply makes no sense to have 59% of your portfolio invested in Canadian stocks. After all, they represent just 3.4% of the world’s total market capitalization.
And with governments around the world slowly lifting restrictions on international stock holdings, there no reason not to hold a globally diversified portfolio.
Or is there?
Today, I am going to make the case for concentrating your entire portfolio in US equities.
That being said, the vast majority of the Banker On FIRE stock portfolio consists of US equities – and below are the reasons why.
At the end of the day, your stock market portfolio has one job and one job only:
Deliver the best possible risk-adjusted returns.
And as the data shows, US equities stand up to the task, with long-term returns that trump every other market:
The chart above plots long-term real (i.e. inflation-adjusted returns) across the world’s stock markets.
At c.4% over the past 80 years, US equities lead the pack.
Compounded over the long run, even minor reductions in returns make a massive difference to the value of your portfolio.
So while there is a case to be made for international diversification, it comes at a price. Are you ready to pay it?
In addition to delivering higher returns, US equities are also cheaper to own.
Taking Vanguard as an example, the FTSE All-World ETF has an OCF of 0.22%. At the same time, the OCF for an S&P 500 ETF is only 0.07%.
Call me cheap but I’ll take a 0.15% reduction in fees any day of the year.
The good news is that the fee differential is shrinking with time. The bad news is that it’s still there.
As someone much smarter than me once said: “The returns come and go, but the fees are always there”.
No one is perfect and the next Enron could always be lurking just around the corner.
A lot of things are forgiven when a massive rising tide lifts all boats the way it has been recently.
That being said, US-listed companies are subject to much higher governance standards than those listed on other exchanges, particularly in the emerging markets.
Those of you old enough to remember BRICs remember the days when Brazil, Russia, India, and China were all the rage.
Two decades and more than a couple of scandals later, we know better.
As a stock market investor, you become a partial owner of the companies whose stock you own.
When the company stops acting in the interests of its shareholders, things usually don’t end well.
Just ask anyone unlucky enough to have invested in Petrobras or Gazprom.
The usual argument for the world index is to secure exposure to as many economies as possible.
However, don’t overlook the fact that US companies, especially the biggest ones, already have a global presence.
For example, the S&P 500 constituents typically generate about 40 – 45% of their sales from foreign countries.
So even if your portfolio consists of 100% US equities, you will still get extensive global exposure.
Best Performing Companies Gravitate Towards The US
As an investment banker, I spend a lot of time with companies who are contemplating an IPO.
With very few exceptions, the most successful companies look to list on US stock exchanges.
The reasons for this are varied.
It’s the depth and liquidity of the markets. Ability to access a pool of experienced, sophisticated investors.
Or simply the prestige of being listed together with some of the world’s leading businesses.
This is why international companies like Alibaba, Spotify, Philip Morris, Lululemon, Shopify, and many others opted for a US listing.
Sometimes they also choose to list their stocks domestically (in what is known as a dual listing).
Still, make no mistake – the US stock market is the place to go if you want exposure to the best companies that are shaping the world.
Capital Trumps Labour
This is a contentious topic, but I’ll mention it anyway.
The two biggest factors of production are capital (provided by shareholders) and labour (provided by employees).
When it comes to capturing a piece of the value created by companies, US shareholders get a much better deal than employees.
I don’t want to get into a debate on the merits of things like two weeks of annual holiday, short maternity leaves, healthcare that’s tied to employment, and limited employment protections.
However, there’s no denying the fact that when employees work as hard as they do in the States, shareholders benefit.
FX Risk Is Overrated
One of the biggest reasons investors favour domestic equities has to do with FX risk.
The thinking usually goes like this: “If I invest in US stocks and the dollar depreciates vs. the pound, the value of my investments will decline”.
Sure it will – there’s no argument here.
But the bigger picture is that investing in lower-returning domestic equities can do much more damage to the value of your portfolio than FX ever will.
Let’s go back to the chart above.
Over the past 80 years, UK equities have underperformed the US by about 1.5% per year.
Forgoing 1.5% annual returns over a period of 30 years is equivalent to the US dollar depreciating from ~1.39 today to ~2.15 in 30 years.
Anything less than that, and you will have been better off in US equities.
Now don’t get me wrong – this has happened before and may well happen again.
However, if the GBP does appreciate this much by the time you retire, the following will also happen:
- You will continue to buy up US equities on the cheap as the USD depreciates, further boosting your returns
- You will benefit from a massive uplift in the value of your other UK assets (house value, cash holdings, etc.)
Bearing the above in mind, I’ll take my chances.
Worst case, I am more than happy to spend a few of my retirement years in the US until the exchange rates normalize.
More likely, I’ll be living it up somewhere nice and warm, taking advantage of the expensive pound.
Which brings me to my next and final point…
The Need To Hedge Existing UK Exposure
Whether we like it or not, but our exposure to the UK (or any other domestic market) goes way beyond our investment portfolio.
Our salaries, bonuses, and cost of living all depend on the success of this country.
Our job security is highly correlated with the UK economic cycle.
And the sterling-denominated values of our houses typically represent a sizeable component of our net worth.
Given the extent of the exposure, it is imperative to protect our finances against a UK economic downturn.
And when it comes to my family’s economic security, I can’t think of a better – or a simpler – way to hedge our fortunes than rebalance our portfolio to US stocks.
At the end of the day, you’ve got to come up with a sensible portfolio allocation that reflects your investment philosophy and objectives.
However, when it comes to long-term investing, every single basis point of returns makes a massive difference.
So before you dial back on US equity exposure, you need to make sure you are not leaving money on the table – all while getting nothing in return.
Have a good weekend – and happy (US) investing!
About Banker On Fire
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Banker On FIRE is a London-based M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
Find out more about me and this blog here.
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