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Home>Research & Insights>Fund Times>What Is the Right Amount of International Diversification?

What Is the Right Amount of International Diversification?

Whatever amount you wish (within reason).

John Rekenthaler, 09/01/2017

Clear Heads
Tuesday’s column elicited this response in the comments section: “Gee, all this mumbo jumbo … I could have had a V-8 and vodka with plenty of ice … I may have awoken with a headache but I wouldn’t have gone to bed with one … “

Fair enough. That article came without cost, calories, or potential liver damage, which are three tallies in its favor when compared with the commenter’s usual method of achieving a headache. However, it buried the central point—that while the famed Capital Asset Pricing Model suggests that all stock investors should own the same U.S. stock portfolio, real-world considerations argue otherwise. Sorry about that.

I will address today’s topic of international diversification more directly.

Two Extremes
The first thing to note is that Tuesday’s argument against the CAPM continues to apply. Given certain assumptions, some have argued that all investors around the globe should possess a single portfolio, which consists of an index of all publicly traded stocks and bonds. (For purposes of this discussion, we’ll ignore other asset classes, as well as private securities.) However, those assumptions do not hold in practice, rendering that recommendation moot.

(For the clearest words ever written by a Nobel Laureate about investments, I recommend Sections 3 and 4 of “A Global Capital Asset Pricing Model”, co-authored by Professor William Sharpe. Those passages will induce no headaches.)

In addition, there is the added complication of currencies. Famously, Jack Bogle has stated that because U.S. investors pay their obligations in dollars, they should invest in dollars. This implies U.S. investors should own only domestic securities. (They could also buy issues from countries that peg their currencies to the dollar, but that brings the risk of damage caused by sudden devaluations.)

That advice has been widely derided, as exemplifying an old-school mentality that might have been appropriate when the United States was the economic superpower, but which is hopelessly outdated today. Well, maybe. Then again, Bogle has not made a habit of being outmoded (aside from perhaps his criticism of exchange-traded funds, depending on your view of the matter), and in this particular opinion he is joined by Warren Buffett. Generally, I don’t favor appeals to authority—but I make an exception when Bogle and Buffett join forces.

is vice president of research for Morningstar.

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