A Good Time to Add Geographic Diversification

Almost all investors are aware of the need for diversification in their portfolio. They often carefully consider the number of sectors, industries and individual stocks in an industry that are contained in their holdings so as not to be overexposed to any one area. They look at the ratio of small companies to large, and of bonds to stocks, and they carefully keep these things in balance. All of that is laudable, but there is one area where most American investors, whether self-directed or guided by an advisor, fall woefully short: international exposure.

The U.S. accounts for only around 16 percent of global GDP and around 49 percent of the global stock market in terms of valuation, yet, when investment firm SigFig analyzed over a quarter of a million accounts last year they found that around 60 percent of them had less than 10 percent in international investments. Some degree of home bias is inevitable. A combination of patriotism and familiarity makes that a comfortable state for many, but international exposure can smooth out the bumps in the market and in many cases juice returns during good times.

If you are underexposed to international stocks now is a good time to rectify that. The strong dollar may cause problems for some US exporting firms, but it makes stocks denominated in other currencies look cheap. That is particularly true when it comes to Europe, where weak economic growth and a relatively weak Euro have caused a big decline. The Vanguard FTSE Europe ETF (VGK), for example is, despite the beginnings of a recovery in the last couple of weeks, down nearly 20 percent from the middle of last year.

Of course there are perfectly legitimate reasons for that. The Euro zone spent the second half of last year battling the prospect of deflation and, while now out of the headlines some EU members, most noticeably Greece, are still dealing with massive unemployment and dangerous debt levels. That, however, doesn’t represent an immediate threat given that the other countries in the Union have committed to avert a Greek tragedy, and the ECB has been vocal about doing “whatever it takes” to avoid deflation.

That commitment from the central bank and the likely implications for actual policy are the foundation of the argument for investing in European equities now. ECB President Mario Draghi talks a big game and is certainly doing enough with their version of QE to support European stock markets. What has happened in the past, however, is that actual policies that address the problem but seriously weaken the currency have been avoided. That is almost inevitable and will probably happen again.

The strongest influence on policy in the EU is the strongest economy there, Germany, and they have good historical reasons for fearing any inflationary push that may result in significant currency devaluation. Inflation and currency collapse ushered in Hitler’s Nazi party in the 1930s and avoiding any repeat of those kinds of conditions is, naturally enough, at the top of any German politician’s agenda.

That said, though, even the Germans now recognize that deflation is also an issue. The policies that have resulted from that recognition but a reluctance to push too far have look likely to have a predictable set of consequences. The added liquidity from QE will cause at least some asset inflation and therefore put upward pressure on stocks, just as the Fed’s similar policy did in the U.S. When push comes to shove, however, just as was the case last quarter, it is likely that Draghi will limit actions to a point where currency damage is limited.

Put all of that together and you have a recipe for both the Euro and stocks to gain ground, making an investment in European stocks through something like VGK look doubly attractive. There may well be no better time for investors to add to the geographical diversification of their portfolios and invest in Europe.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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