Home country bias is alive and well in America. The US accounts for around 20% of the World's GDP and the capitalization of the US stock market represents around 45% of the global total, yet how many investors have the majority of their money invested globally? Not too many. On average, American investors have about a 20% exposure to international markets.
Let me make one thing clear ... there's nothing wrong with that. In theory, investing should be done in a logical, analytical way with one's only goal being to maximize return. In practice it is anything but. We invest in the country where we live for many reasons, convenience, familiarity and transparency being the most obvious. It is also a function of the way most people gauge investing success. When it became clear that US stocks appreciated 30% in 2013 that became the benchmark by which most people judged their performance.
This is infuriating for Financial Advisors in some ways. Everybody who has ever done the job, and I am one of those, has multiple stories of people who come to them looking for low risk, secure investments and then complain bitterly when their account grows 15% in a year like last year. In that case, explaining that risk equates to reward can be difficult, but can usually be done. Investing clients' money in underperforming overseas markets that are perceived as risky, however, as things boom at home, is usually less easily forgiven.
This perception of risk is, in some ways, fundamentally flawed. I have pointed out a few times in these pages that sometimes, even though an individual investment may be risky per se, including it in a portfolio can, through the magic of diversification, reduce overall risk and so it is with international stock investing. The US was a great place to invest last year, but that doesn't mean it will be this year. I happen to think it will be OK, but I also think there will be more opportunity elsewhere. To find the best opportunity I started from a broad base, then narrowed down. I ended up not too far from home.
A broad way of playing international stocks would be through something like the Vanguard Total International ETF (VXUS). This fund's regional allocation is about 47% to Europe, 28% to the Asia Pacific region and 17% to emerging markets. On the surface this appears not to be particularly risky with only a small percentage in emerging markets, but if I see an international risk this year, it is in Europe. Unemployment in the Southern European countries is still extremely high, particularly youth unemployment, and until that situation normalizes there is too much chance of a major disruption and I don't want too much exposure to the region.
The Asia Pacific region and some emerging markets, however, could be worth diversifying into. The latter area was a major disappointment for me and many others last year. As the developed world roared on, stocks in developing countries underperformed woefully.
Given that underperformance it is tempting to recommend a general emerging market ETF, such as the Vanguard Emerging Market Fund (VWO) which lost 7.6% last year. Some improvement this year is to be expected, but not all emerging markets move together and a little more selectivity may be the best strategy this year.
There will undoubtedly be a lot of focus on Latin America this year with Brazil hosting the World Cup and one of the best opportunities for 2014 may come from that region, but not from Brazil, where any benefit accrued from that competition is already priced in. Mexico has underperformed for the last few years, even in comparison to other underperforming countries. Stories coming out of the US's southern neighbor have been about drug cartels and violence rather than growth, but a change of government and a liberalization of energy markets should be catalysts for a turn around.
The iShares MSCI Mexico Investable Market Fund (EWW) is, in fact, one of my top picks for 2014. The aforementioned privatization of the energy market will open the way for significant foreign investment into the country and the resulting improving economic conditions, combined with some sweeping social changes that the new government has made, offer a good chance of stimulating serious growth. After bouncing around in 2013, EWW finished the year essentially flat. There will probably be more volatility this year, but the stage is set for much better performance.
So, if you are looking to diversify outside US borders for 2014, don't look too far. I am not sure that investing in Mexico is truly diversification away from the US given the dependency on the big brother to the North for trade, but the opportunity looks too good to miss.