Properly diversifying your portfolio across asset classes, markets, sectors, currencies and financial instruments is a serious undertaking, but by removing home bias you can maximise rewards and minimise risks.
Christian Armbruester, Chief Investment Officer at Blu Family Office, explains why home bias is likely to seriously damage long-term returns and outlines key concepts in building a globally diversified portfolio that minimises risk.
There is no place like home and so it is when it comes to our investments. We tend to skew our allocations more heavily to the country we live in. It is estimated that the average UK investor holds more than half of their investments in domestic securities. Yet, Great Britain accounts for only about 3% of global GDP and has less than 1% of the planet’s total population. Why the bias, does it make sense, and should UK investors think more globally in their asset allocation? These are the questions we wish to explore as we aim to invest our monies most optimally.
It is estimated that the average UK investor holds more than half of their investments in domestic securities. Yet, Great Britain accounts for only about 3% of global GDP and has less than 1% of the planet’s total population
According to a study by Morningstar, 24% of UK investors only hold UK stocks as part of their allocation to equities. In today’s highly efficient and sophisticated financial system, it is not that we can’t buy stocks (or bonds) from outside of our domain. It is just as easy to buy Vodafone as it is Apple or BMW and we can even acquire these stocks on a UK exchange, denominated in sterling. So, the inertia to buy UK businesses clearly has to do with something other than access. Patriotism can partly explain why investors choose one over the other. Maybe also familiarity. After all, when you shop at Sainsbury’s, you may feel more comfortable buying those shares, than you would those of Albert Heijn, which is what our Dutch friends are putting in their portfolio.
Benchmarking can be another reason. People living in the UK will look at the FTSE 100, as their main equity index, just as much as our German compatriots will follow the DAX. As such, buying shares in the country of origin for these indices makes it easier to compare and measure how we are doing with our investments relative to something else. I think it also has to do with the sales process, and people selling equity funds, research or providing financial advice, will also be more adept in things going on in their own country. Of course, so will the investor and that common knowledge base will make it much easier to come to terms on a portfolio of things we know, versus making a sale about Norwegian fishing companies.
The thing is, it doesn’t really matter what our reasoning is for doing the things we do because investing in the UK only, rather than the entire world, has evidently been a bad idea. In 2019 alone, the MSCI World Index returned almost double the performance of the FTSE 100. Surely one year does not make a trend. So, what about the long term? Since the 1980s, the main UK stock index has delivered 548% less returns than that of an index containing the major stocks from the rest of the word.
Of course, there are many reasons to explain the difference in returns. The UK index lacks the large technology component of the American companies or the industrial strength of other European or Chinese businesses, which have driven stock market valuations to record highs. There are also the currencies and a strong British pound can explain some of the underperformance leading up to the financial crisis. However, since then, that trend has strongly reversed and we are almost back to where we started in the early 1980s, as regards the exchange rate of sterling and the US dollar.
Since the 1980s, the main UK stock index has delivered 548% less returns than that of an index containing the major stocks from the rest of the word
All in all, it seems to make little sense to buy anything other than what has proven to be the sounder investment for many decades. The UK investor is better off having exposure to a globally diversified index of stocks from all regions, countries and sectors. It is very easy, and we can buy the MSCI World Index in an ETF from our friendly neighbourhood asset management behemoths, like Vanguard or BlackRock. The whole thing will cost less than 0.10% and we get exposure to thousands of stocks from all over the world.
We constantly bang the drum for proper portfolio diversification, since this is your best bet for maximising returns and minimising risk. But achieving – and maintaining – rigorous diversification across asset classes, markets, sectors, currencies and financial instruments is a weighty task indeed for those going it alone. Why not let a professional adviser backed by a research team take the strain? Finding your best options is easy and fast with our smart matching tool.
What about bonds? This is where it gets complicated and where currencies make things difficult. It’s fine putting some of our money at risk by buying shares from all over the world, but of course, we live in a world of money. Fact is, UK investors need sterling, just like Brazilians will want real and the people of Japan will want yen. The problem with exchanging our money into other currencies is the risk of that rate moving. This can alter our returns greatly, particularly depending on how much of our money we convert. Imagine buying investments in other currencies that make a return of 10% in a year, but the rate of exchange going down by 20%? Then we have lost 10%.
Over time that may be less of a problem, as currencies tend to revert around means and business cycles. Sterling, for example, is now virtually at the same exchange rate to the US dollar as it was 40 years ago. But of course, in the short term it matters greatly and particularly if we need money in our own currency to live on. Therefore, we must keep part of our money in our (base) currency to manage our income needs, which allows us to take risk and grow our assets with the rest of the money.
Imagine buying investments in other currencies that make a return of 10% in a year, but the rate of exchange going down by 20%? Then we have lost 10%
Buying UK government or corporate bonds give us the yield we need and helps us manage our currency risk. We need to make sure the loans are secure or, at the very least, we get compensated for the risk we take on, as would be the case with so called “high-yield” or non-investment grade bonds. And we need to make sure we diversify our overall duration as in short-, medium- and long-term debt. We could also buy an international portfolio of bonds that are fully hedged back to sterling, which again can be done using low cost ETFs that track broad indices. The yields after hedging are the same as for comparable bonds denominated in sterling, thanks to a concept called “interest rate parity”. But at least we can diversify our country risk and there really seems very little reason not to do that for UK investors.