Blogs & Comment

Warming up to foreign diversification

I confess to having a home equity bias (as is evident in the One-Minute Portfolio) but Im becoming more receptive to foreign diversification after revisiting Jeremy Siegels The Future for Investors. Indeed, I am even thinking about adding foreign exposure tothe One-Minute Portfolio, particularly as the Canadian dollar closes in on parity with the U.S. dollar.
One main reason for unease about foreign diversification was the additional risk incurred by currency fluctuations. I know there are analysts who claim, on the basis of empirical studies, that currency fluctuations average out over the long run. But, if true, I didnt see how there could be any guarantee that the foreign currency would necessarily return to breakeven or a positive gain within the range of years when retirement commences. Moreover, economic history shows many currencies have collapsed outright and gone into lengthy downward spirals — a fat tail risk that concerned me (and is no longer necessarily the preserve of Latin American currencies as attested to by the many articles/books on the demise of the U.S. dollar).
From what Siegel says, it would appear the fat-tail riskshould not bemuch of a concern after all. He writes: Over the long run, movements in exchange rates are determined by relative inflation between the countries, and stock returns will compensate investors for this difference in inflation.
In other words, a country with a tumbling currency usually is also experiencing substantial inflation, which, in turn, carries the prices of domestic stocks upward. When inflation comes, investors run to tangible assets such as precious metals, real estate and stocks, goes the logic. Siegel gives the examples of Brazil: Since 1992, the Brazilian currency has depreciated more than eighty times relative to the dollar [as of 2005], but this was more than compensated for by appreciation of Brazilian stocks.
Siegel has some other interesting observations on international diversification:
Rising correlations between global equities may reduce diversification benefit but still do not support concentrating on domestic equities because you will be drawing from a smaller sample of value and growth investment opportunities.
As companies become more multinational, your portfolio achieves foreign diversification not so much by where companies are domiciled but where their lines of businesses are spread across the globe (U.S. investors indexed to the S&P 500 already have more than 20% foreign diversification thanks to the foreign operations of S&P 500 companies)
Diversifying into another country per se may not be so important as diversifying into countries for the sake of gaining exposure to industrial sectors under-represented in your home country
Recommended weight for foreign-based holdings of equities is 40%
While I have been lukewarm toforeign diversification in the past, I have been open to branching outside of Canada when the loonie is strong (close to, or above, parity). I think this greatly increases the odds of long-run currency movements canceling out or even adding to portfolio returns by the time retirement comes. Now Siegels perspectives give me more impetus to follow through.